Advanced trading strategies
Interest rate trading
Interest rates are an important driver for forex markets and are therefore consequential for traders looking at fundamental and technical analysis alike. Read on for an example of a forex interest rate carry trade strategy for a relevant currency pair.
- How do interest rates affect forex trading?
- How interest rates are calculated
- Dot plot interest rates
- Currency carry trades
- Forex interest rate trading strategy
- Key interest rate trading takeaways
How do interest rates affect forex trading?
Interest rates affect forex trading by shaping how a currency’s value is perceived. Therefore, any change in the interest rate will impact forex, meaning forex traders should always be aware of when their national central bank’s interest rate announcements occur.
How interest rates are calculated
Interest rates are calculated via the central banks’ board of directors. Rates can be hiked to curb inflation or cut to encourage lending in the economy. Economic indicators like the CPI, housing market conditions, employment statistics, and consumer spending can all give clues to the direction of interest rates.
Dot plot interest rates
Dot plot interest rates can help traders understand the Fed’s interest rate forecast at certain FOMC meetings. This method of data visualization shows the projections by FOMC members for interest rates in future years, plotted as dots on a graph. When the median of the dots on the dot plot is calculated, this may give an overall FOMC outlook for rates.
In the below example, each dot represents each FOMC member’s view on where interest rates should be at the end of the year.
Currency carry trades
A currency carry trade is where a trader borrows or sells a low interest rate currency in order to purchase another currency with a higher interest rate. Carry trades may be popular where the interest rate spread between the two currencies is high. This is because paying a low rate on the borrowed currency potentially allows for a return on the higher rate of the purchased currency.
In simple terms, if you go long on a pair like AUD/JPY, where the Australian Dollar has a higher interest rate than the Japanese yen, you are making a carry trade. In effect, you are borrowing money from Japan to invest in the Australian dollar where your money will earn more interest each day than it would if it was held in yen. Essentially, the broker will be paying the interest rate differential between the two currencies, minus the spread. It’s important to keep in mind that this interest rate differential will be added to whatever gains or losses the Australian dollar experiences in value against the yen.
Forex interest rate trading strategy
When putting together an interest rate trading strategy, consider that every currency pair will be beholden to interest rate decisions that affect the relevant country. Therefore, traders should be aware of when the next central bank meetings pertinent to their pair will take place. To ensure you’re on top of the latest announcements, be sure to check out our economic calendar.
Being cognizant of central bank policy will mean you aren’t caught off-guard by unexpected market movements, like when making a purely technical trade based on Fibonacci retracement levels.
Next, you need to check the charts and use multi-timeframe analysis to assess trends. For example, looking at a chart with a timeframe 4-6 times higher than the chart you plan to trade on can give a helpful idea of a range, whether it’s an uptrend, downtrend, or a ranging market. When making a long-term carry trade, for instance, it may be worth assessing the durability of an uptrend on a daily chart, but actually place the trade on a 4-hour chart.
When making this trade, effective risk management processes are essential. If the trend changes or the interest rate differential narrows, heightened losses can arise. This means that traders may want to consider tighter stops to lessen the impact of a reversal, so they can reassess the market conditions without maintaining a losing trade.
Key interest rate trading takeaways
- Be aware of when interest rate decisions are released by central banks
- Refer to dot plots for an idea of future rates
- Trade the FX pairs with significant interest rate spreads
- Use multi-timeframe analysis to assess broader trends
- Employ technical analysis to assist with entries and exits
- Ensure your risk management is on point, as a reversal could be damaging to your balance