Interest rates, or more importantly, the expectations of future interest rates, are probably the most significant factors that influence forex markets.
The reason for this is that market participants will naturally move their money towards those currencies with the highest yields as those yields give the best return for their money. Those countries with the higher interest rates will therefore see much larger inflows of money coming into their currencies.
Guest post by FXTM
As a general rule then, countries with higher rates should see their currency appreciate while those countries with lower rates should see their currency weaken.
However, as noted above, the real key to predicting forex markets is identifying where interest rates are headed before they go there. Since, by the time a county has raised interest rates, that decision will likely have already been priced into the market (and that country’s currency will already have become stronger.).
The solution therefore, is to recognise that market expectations are the key driver for all forex markets.
If rates have been dropping for a while, for example, and traders suddenly decide that they have hit bottom, they will begin buying up the currency, well in advance of interest rates going up.
In fact, sometimes the very act of traders changing their market views can alter the economic environment enough to influence future outcomes.
It is therefore important to understand news releases and economic reports as they can act to change the sentiment among traders, even if the opinion among central banks remain the same. Equally, it is just as likely for the market to price in events that do not end up transpiring in real life.
For example, let us look at the most recent FOMC policy meeting whereby Fed governor Ben Bernanke went against market expectations and kept current levels of QE unchanged at $85bn per month.
Running up to the event, the market had become convinced that Bernanke would ‘taper’ asset purchases, so much so that traders sold down stocks and bought up the US dollar. (Since tapering is hawkish and deflationary this act would in theory be bullish for the US dollar).
However, Bernanke surprised the market and did not taper. The result saw stocks advance and the US dollar give up most of its gains in a short time as traders reacted once more to the change in expectations.
The funny thing is, Bernanke had not actually given any indication that he would taper in the last meeting, but a series of positive economic releases had convinced traders that he would. As you can see, most of the time it pays to move with market sentiment in order to track the various trends in the market. However, in certain instances, like the example above, it can pay even more to go against market sentiment when there is enough risk/ reward in doing so.