How do interest rates affect the forex market

Interest rate is the most important factor in determining the currency value.  It is commonly used by Central Banks to curb down inflation and for price stability. The fact that forex trading involves the trading of currencies, interest rates have a direct impact on the forex market.

When interest rates are increased, it becomes more expensive for people to borrow  money from banks, to spend and at the same time encourages people to save with the bank to earn a high interest yield on savings.

By doing so, money is restricted from going into circulation and more of it is held in banks through savings. This reduces on the amount available to spend and leads to increase in prices hence strengthening the domestic currency.

High interest rates also attract foreign investors looking for high yield returns on their investments causing more demand for the currency in question which leads to increase in its value.

During the period when interest rates are raised, we see big price movements in the forex market on the bullish side due to more buyers investing in the currency in question.

On the other hand, when the interest rates are cut, the cost of borrowing becomes cheaper and low incentive to save, increasing the amount of money in circulation to spend hence weakening the domestic currency.

When a lot of money is in circulation, people spend more than they can save leading to excess demand over supply hence increasing prices of goods and services.  At the same time, the foreign goods will become expensive due to the loss of value in the currency and if this continues may lead to hyper inflation in a long run.

Forex traders will not feel safe to hold their money in a losing currency therefore are likely to sell it off buying a higher yielding currency. This is likely to cause strong down movements in the forex market due to most investors liquidating their accounts to invest in higher yielding currencies.

Major sources that release Interest rate announcements are listed in the table below

The interest rates are adjusted by the central banks when necessary to stablise prices and improve on the economic growth. Both high and low interest rates are needed in the economy for stability and growth. Well investors use interest rates to determine the more viable ventures that can accrue profits on their investments and savings

 Nominal interest vs Real interest rate

The nominal interest rate is the rate at which you borrow money from your bank before deducting inflation rate. The nominal interest is set by the central bank on which commercial banks operate. For example, if you borrow $100 at a 3% interest rate, you are expected to pay back $100 with $3 in interest without taking inflation into consideration.

The real interest rate is got by reducing the nominal rate by inflation rate.

Real interest rate = Nominal interest rate-Expected inflation

 If the nominal interest rate is 10% and the expected inflation rate is 5.5%,

The real interest rate will be; (10%-5.5% ) = 4.5%.

A 5.5% inflation rate means that an average basket of goods to be purchased this year is 5% more expensive when compared to last year.

The real interest rate measures the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest. From the above example the lender expected to earn 10% interest. However, because inflation rose to 5.5% over the same time period, the lender actually earned only 4.5% in real purchasing power.

If you are investing in currencies and securities  e.g bonds its face value can be affected by inflation. What do I mean, if the nominal face value of a bond is 9% but the annual inflation is 7%, that means its real yield would be 2% on the market price. The best choice for an investor would be to hold the bond till it appreciates again or matures either to its normal value or above; if he or she misses out to sell before inflation. 

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