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Economic Indicators: Why US Federal Interest Rates Matter so Much in Forex

   

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It might sound obvious, but US federal interest rates have a humongous impact on the forex market, especially when it changes to those rates occur. Changes to the US federal interest rate can move the forex market at full force, as they are a direct or indirect response to other, alternative economic indicators. Rate changes can also come as a surprise, potentially impacting traders in a big way, so it is important that traders know how to predict and respond to these movements.

The Basics of US Federal Interest Rates

Forex traders regard US federal interest rates as incredibly important. Through whatever shifts might occur, currency fluctuation is likely, which can be a dramatic offset to any forex trading strategy. While you may always tend towards buying currencies with higher interest—funding them with currencies of lower interest—this isn’t always a wise move to make. The forex market just isn’t that easy, especially when you factor US federal interest rate shifts into the equation. Now, that’s not to say that interest rates are too complex for the run-of-the-mill forex trader to navigate, but traders should practice caution. Interest rates should be viewed through wary eyes, just like any of the other regular news releases that come out through the month.

For example, during fall 2017, the Federal Reserve made the call to lift its federal interest rates range target by a quarter point, from 1.25% to 1.50%. This saw the GBP/USD shift to 1.3355 after the release, while the EUR/USD followed a similar path to 1.1757, with the USD weakening. This shift tells quite the story; the US federal interest rates are not to be ignored by any forex trader.

How US Federal Interest Rates Are Calculated

The monetary policy of a country, and therefore the short-term interest rate at which banks can lend from each other, is controlled by the central bank. The same applies to US federal interest rates. The central global banks will curb inflation by raising rates or encourage lending by cutting rates. You can have a vague idea of what the banks will opt for by taking a look at the most relevant economic indicators, such as the following:

  • Consumer Price Index (CPI)
  • Consumer spending
  • Employment levels
  • Housing market performance

Staying Ahead of US Federal Interest Rate Changes

By arming yourself with data from the above indicators, you as a trader can estimate how the US federal interest rates will change. As indicators are improving, so is the economy, and traders can estimate that the rates will be raised or stay the same. However, drops in the indicators above can herald a rate cut, and could be a sign that traders need to heed warnings.

You can also predict rate decisions by keeping an eye out for major announcements and analyzing market forecasts. Major announcements will more than likely play a big role when it comes to interest rate changes, but are generally underestimated as long-term market indicators. Any time that there is a public discussion including the Federal Reserve, there will often be insight into how the bank currently views inflation. When these do occur, it will certainly make sense to listen to what’s being said if you value your forex efforts.

Analyzing forecasts and predictions will always be useful, because interest rates are usually pretty well anticipated by brokerages, professional traders, and banks. A good strategy is to take four or five of the forecasts, which should all have close results, and average them in order to get an accurate prediction of what’s ahead.

How to Trade US Federal Interest Rates

It’s important to note that no matter the research you’ve done or data you may have crunched, the Federal Reserve can always throw a curveball of sorts your way with a surprise rate interest rate hike or cut. If this should happen, you should be prepared by knowing how the market will move. If the rate is hiked, for example, the currency will appreciate, and traders will be buying that currency. Conversely, if the rate is cut, traders are more likely to sell and instead buy currencies with higher interest rates.

Swift action is paramount at this point. The market will move incredibly quickly when a surprise rate change hits, as all traders want to be ahead of the crowd. Beware of volatile reversals; a trader’s perception will rule the market for a short time, and then logic will step in and the trend will more likely continue on its way. After you determine whether or not there has been a surprise rate change, you’ll want to read through the actual press release from the Federal Reserve in order to gain understanding of how the central bank sees future rate decisions.

Conclusion

By following economic news and events, in addition to analyzing how the Federal Reserve acts, forex traders can get a grasp on monetary policy and how the currency exchange rates will move as a result. As currency exchange rates shift, traders can maximize profit by working around fluctuations in market performance. Bracing for surprise changes to US federal interest rates and reacting to the ones you can’t dodge are some of the greatest tools in a trader’s toolbox.

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Disclaimer:

The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.

This post was written by Graeme Watkins

CEO Valutrades Limited, Graeme Watkins is an FX and CFD market veteran with more than 10 years experience. Key roles include management, senior systems and controls, sales, project management and operations. Graeme has help significant roles for both brokerages and technology platforms.

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