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Interest Rate Expectations in the Forex Market

By , Forex Trading Instructor
06 December 2011 19:58 GMT

Interest Rate Expectations; the Culprit of Many Moves in the Forex Market

Many traders understand the mannerism in which interest rates affect the FX Market. In many cases, Higher-Yielding currencies can attract additional capital flows and, in turn, appreciate in value. This is often referred to as ‘The Carry Trade.’ But few traders know the full extent of the relationship between interest rates and currency prices.

Let’s take a look at one of the more recent stories of ‘The Carry Trade,’ with the AUD/USD currency pair throughout 2010. Below is a chart of the Aussie throughout 2010.

Interest_Rate_Expectations_the_culprit_body_Picture_2.png, Interest Rate Expectations in the Forex Market

Created with Marketscope/Trading Station 2

In the above chart, you’ll see the beginning and end of the trading year encompassed by dark vertical lines. During 2010, Australia maintained one of the highest interest rates of modern economies. Throughout the year, the currency gained over 1250 pips of value.

The United States, representing the counter currency in the AUD/USD pair held extremely low interest rates throughout 2010 – with the Aussie clearly enjoying an interest rate advantage. As the Aussie had a higher interest rate throughout the year, the 1250 pip appreciation in value can make sense.

Think of it from your perspective. As an investor with cash to invest, would you rather pick a higher interest rate or a lower interest rate?

In many scenarios the popular answer to that question is that the investor would enjoy higher interest rates, and would invest accordingly.

But as you can see from the chart, and as you can probably imagine, that is not always the case. As a matter of fact, if you notice, almost the entire first half of the chart is showing very ‘curious,’ price action considering the strong interest rate differential.

This highlights one of the more pertinent facts that traders should know. Interest rates don’t necessarily influence currency prices as much as interest rate expectations might.

Throughout the first portion of 2010 much of the international community kept a keen and watchful eye on global economic metrics for fear of a recession. As these fears were permeating the economy, we could see investors beginning to position themselves in anticipation of a potential recession. If a global recession were to affect the global economy (to the scope that was anticipated in 2010) many investors expect interest rates to be cut.

Central banks will generally cut interest rates in an attempt to stimulate the economy.

Investors will often look to sell out of their higher-yielding securities in an attempt to cushion the blow that any potential recession may bring to their portfolios, and hopefully, do so before interest rate cuts actually begin taking place.

This is where we can see a ‘flight-to-quality,’ in financial markets, with investors choosing to eschew higher rates of returns for, instead, safety of capital. Assets such as the US Dollar or US Treasury Bills are often attractive instruments in these cases; even given the fact that yields may be lower.

In the second half of 2010, the US Treasury department continued with their Quantitative Easing program in an attempt to stave off the recessionary fears that were so pervasive in the markets for the first half of 2010. And as you can see from the chart above, with recessionary fears quenched, the Aussie-Dollar traded higher, eventually creating an all-time high in 2011.

But it wasn’t only interest rates that created these moves. Expectations played a very large role.

Additional resources:

DailyFX PLUS Online Video Course – Money Management Lesson 1

Clarifying the 5% Money Management Rule

In-Trade Management

--- Written by James B. Stanley

To contact James Stanley, please email Instructor@DailyFX.Com. You can follow James on Twitter @JStanleyFX.

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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06 December 2011 19:58 GMT