Fundamental Trading Strategy Based on Interest Rate Differentials
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 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 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 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, 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.
Lets take an example, suppose the Australian 10-year government bond yield is 5.25%. The US 10-year government bond yield is 1.75%. The yield spread in this case would be 350 basis points in favor of the Australian Dollar.
Suppose the Australian government raised its interest rate by 25 basis points. The 10 year Australian government bond yield would also appreciate to 5.50%. Now, the new yield spread is 375 basis points in favor of AUD. The AUD will also be expected to appreciate against USD.
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.
