Interest Rates and Their Role on Forex

When looking at the economic calendar you might have noticed monetary policy meetings of world major central banks. The days when CBs meet to review their benchmark interest rates are considered the most important for every Forex trader as these days volatility may be at a high level.

Every country has many interest rates. Some of these rates serve for lending programs initiated by central banks, at some interest rates commercial banks exchange their funds. However, all these rates are based on a single rate, provided by the major financial institution of the country. If we compare official interest rates of two countries, we would find an essential difference. This differencial will show us relative attractiveness of a currency. This difference may be treated as grounds for long term trend of financial flows. If the differencial between interest rates of two countries is high, financial flow is directed from a low rated country to the other one with high rates until other shifts happen.

These countries, where the rates are high have the currencies called high yielding. For example in Australia Cash rate, imposed by the Reserve Bank of Australia is currently at 4.5%, thus, we may call the Australian dollar (Aussie) a high yielding currency. On the contrary, in Japan the rates have been at low level for ages. Today Japanese Overnight Call Rate Target stands at 0.1%. Japanese yen is called low yielding currency as investors buy the Japanese currency in times of global economic turmoil.

Nevertheless, you should not think that if a central bank sets a high interest rate level it always brings you good profit. Having a bank deposit in a country, which has the benchmark interest rate above 10% (very common for Asian and African counties, but unfamiliar in Europe) may bear additional risks such an inflation. If the rate is above 10% it may probably mean that inflation rate is also above this mark. It means that at the end you`ll find out that you`ve lost more than earned.

The influence on Forex market

So now, how may we apply interest rate within the frames of currency trading? The higher the demand for the currency, the higher the rate, at least the law of supply and demand points out so. The interest rate is a very important source of demand for a currency. According to the general rule, the currency, which country has a higher rate, would appreciate as compared to the currency of the country, where the rate is lower.

That is why interest rate decisions of major CBs draw attention of traders and cause booming reaction. In the event when the bank lifts its benchmark interest rate, it reflects into immediate rise of its currency. The opposite thing may take place when the bank reduces interest rate. In this case, as well as in case when experts anticipated upward movement, but bank retained it, the currency will fall sharply.

Here is the list of the world`s most important interest rates:
USA - Federal Funds rate
Eurozone - Refinancing Tender
Japan - Overnight Call Rate Target
Great Britain – Bank Rate
Switzerland - 3 Month Libor Rate