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 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. In addition to the Central Banks overnight interest rate decisions, expected future overnight rates as well the expected timing for the rate changes can be critical to the currency pair movements.
The reason why it is profitable is that international investors like hedge funds, big banks 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.
Lets use an example to make it clear. Suppose the Australian 10 year government bond yield is 5.25%. The US 10 year government bond yield is 1.75%. The yield spread between AUD and USD would be 350 basis points in favor of the AUD.
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 is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against other currencies. This information should be very important for your trading. Use the data available on Bloomberg to keep track of currencies in the currency pairs that you trade. - 23212
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. In addition to the Central Banks overnight interest rate decisions, expected future overnight rates as well the expected timing for the rate changes can be critical to the currency pair movements.
The reason why it is profitable is that international investors like hedge funds, big banks 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.
Lets use an example to make it clear. Suppose the Australian 10 year government bond yield is 5.25%. The US 10 year government bond yield is 1.75%. The yield spread between AUD and USD would be 350 basis points in favor of the AUD.
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 is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against other currencies. This information should be very important for your trading. Use the data available on Bloomberg to keep track of currencies in the currency pairs that you trade. - 23212
About the Author:
Mr. Ahmad Hassam is a Harvard University Graduate. 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 @ 1:35 AM
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