Using Interest Rate Differentials as Fundamental Trading Strategy
Any forex trader knows that interest rates are an integral part of investment decisions and can drive the currency as well as the stock markets in either direction. FOMC rate decisions are the second largest currency market moving release behind the unemployment figures.
The impact of interest rate changes is not only short term but also long term on the currency markets. One Central Banks interest rate decision can affect more than a single currency pair in the interconnected forex markets.
In forex trading, an interest rate differential is the difference between the base currency and the counter currency interest rate. In the pair, EUR/USD, Euro is the base currency and US Dollar is the counter currency. The interest rate differential for the EUR/USD currency pair will be the difference between the Euro and the US Dollar interest rate.
Understanding the relationship between the interest rate differentials and the currency pairs can be very profitable for you as a forex trader. In addition to the Central Banks overnight interest rate decisions, expected future overnight rates as well the expected timing for the interest rate changes can be crucial to the currency pair movements.
The reason why this is profitable is that international investors like big banks, hedge funds and institutional investors are yield seekers. They actively keep on shifting funds from the low yield assets to high yield assets.
Interest rate differentials are considered to be the leading indicators for currency prices. London Inter Bank Offer Rate and the 10 year government 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 used by professional traders is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against the other currency in the pair. This is important information for you as a trader. Interest rate data is available on Bloomberg. Keep track of the currencies in the currency pairs that you trade with that data. - 23200
The impact of interest rate changes is not only short term but also long term on the currency markets. One Central Banks interest rate decision can affect more than a single currency pair in the interconnected forex markets.
In forex trading, an interest rate differential is the difference between the base currency and the counter currency interest rate. In the pair, EUR/USD, Euro is the base currency and US Dollar is the counter currency. The interest rate differential for the EUR/USD currency pair will be the difference between the Euro and the US Dollar interest rate.
Understanding the relationship between the interest rate differentials and the currency pairs can be very profitable for you as a forex trader. In addition to the Central Banks overnight interest rate decisions, expected future overnight rates as well the expected timing for the interest rate changes can be crucial to the currency pair movements.
The reason why this is profitable is that international investors like big banks, hedge funds and institutional investors are yield seekers. They actively keep on shifting funds from the low yield assets to high yield assets.
Interest rate differentials are considered to be the leading indicators for currency prices. London Inter Bank Offer Rate and the 10 year government 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 used by professional traders is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against the other currency in the pair. This is important information for you as a trader. Interest rate data is available on Bloomberg. Keep track of the currencies in the currency pairs that you trade with that data. - 23200
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.
posted by X - Men @ 1:27 AM
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