As a forex trader, you should be aware of the role played by the interest rate changes in the general economic and investment climate. You should know that interest rates are an essential part of investment decisions and can drive currency markets as well as the stock and commodities markets in either direction. After the unemployment figures, Federal Open Market Committee (FOMC) rate decisions are the second largest currency market moving release.
The impact of interest rate changes not only have short term consequences but also have long term consequences on forex markets. One Central Banks interest rate change decision can affect more than a single currency pair in the interrelated currency markets.
In currency trading, an interest rate differential is the difference between the base currency interest rate and the counter currency interest rate. In the pair, EUR/USD, EUR is the base currency and USD is the counter currency. The interest rate differential for the EUR/USD pair will be the difference between the Euro interest rate and the US Dollar interest rate.
Understanding the relationship between the interest rate differentials and the currency pairs can be very profitable. In addition to the Central Banks overnight interest rate decisions, expected future overnight rates as well the expected timing for the rate changes can be critical to the currency pair movements.
The reason why this is profitable is that international investors like big banks, corporations, hedge funds and institutional investors are yield seekers. They actively keep on shifting their funds from the low yield assets to high yield assets.
Interest rate differentials are considered to be the leading indicators for currency prices. LIBOR and the 10 year bond yields are usually used as leading indicators of currency movements.
Take an example, suppose the Australian government 10-year bond yield is 5.25%. The US government 10-year bond yield is only 1.75%. The yield spread in this case would be 350 basis points in favor of the AUD.
Suppose the Australian government raised its interest rate by 25 basis points. The Australian 10-year government bond yield would also appreciate to 5.50%. Now, the new yield spread is 375 basis points in favor of the Australian Dollar (AUD). The AUD will also be expected to appreciate against USD overtime.
The general rule of thumb is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against other currencies. This information should be very important for your trading. Use the data available on Bloomberg to keep track of currencies in the currency pairs that you trade. - 22871
The impact of interest rate changes not only have short term consequences but also have long term consequences on forex markets. One Central Banks interest rate change decision can affect more than a single currency pair in the interrelated currency markets.
In currency trading, an interest rate differential is the difference between the base currency interest rate and the counter currency interest rate. In the pair, EUR/USD, EUR is the base currency and USD is the counter currency. The interest rate differential for the EUR/USD pair will be the difference between the Euro interest rate and the US Dollar interest rate.
Understanding the relationship between the interest rate differentials and the currency pairs can be very profitable. In addition to the Central Banks overnight interest rate decisions, expected future overnight rates as well the expected timing for the rate changes can be critical to the currency pair movements.
The reason why this is profitable is that international investors like big banks, corporations, hedge funds and institutional investors are yield seekers. They actively keep on shifting their funds from the low yield assets to high yield assets.
Interest rate differentials are considered to be the leading indicators for currency prices. LIBOR and the 10 year bond yields are usually used as leading indicators of currency movements.
Take an example, suppose the Australian government 10-year bond yield is 5.25%. The US government 10-year bond yield is only 1.75%. The yield spread in this case would be 350 basis points in favor of the AUD.
Suppose the Australian government raised its interest rate by 25 basis points. The Australian 10-year government bond yield would also appreciate to 5.50%. Now, the new yield spread is 375 basis points in favor of the Australian Dollar (AUD). The AUD will also be expected to appreciate against USD overtime.
The general rule of thumb is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against other currencies. This information should be very important for your trading. Use the data available on Bloomberg to keep track of currencies in the currency pairs that you trade. - 22871
About the Author:
Mr. Ahmad Hassam has done Masters from Harvard University. He is interested in day trading and swing trading stocks and currencies. Learn Forex Nitty Gritty. Read about Trend Forex System. Try Netpicks Forex Signal Service.
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