Lesson 7: How Interest Rates Move the Forex Market, Part 2
Lesson 7: How Interest Rates Move the Forex Market, Part 2
In our last lesson we continued our free forex trading course with a look at interest rates and how the capital flows associated with movements in the interest rates of a country affect the value of its currency. Now that we have a basic understanding of how interest rates move the forex market, lets help drive this point home with a specific example from today's market environment.
For our example we are going to say that I am a savvy investor located in the United States who is seeking a good place to park some savings where I can earn a decent return on my money. For this particular slice of my portfolio I am looking for an interest paying instrument that will pay me a steady stream of cash on my money.
As many of you already know a government or corporate bond will do just this paying me whatever the interest rate is as set by the country's central bank that I am investing in, plus an additional interest rate depending on the length of the bond that I am investing in (for example a 1 year bond is generally going to pay me a lower rate of interest than a 10 year bond) and for the extra risk that I take on for different type of bonds (for example a government bond is normally going to pay me less than a corporate bond because there is less chance that the government is going to default on the loan).
So, knowing this, I decide that I would like to invest in a bond that pays me a good rate of interest, and I am not looking to get too speculative about this investment, so I prefer a government bond over a corporate bond. For our example we are going to say for simplicity's sake, that the bonds of the countries that we have available to invest in pay an interest rate equal to the interest rate in the country as set by the central bank.
Now with this in mind the next thing that I do is list out all the different interest rates for the major countries of the world and I come up with:
United States: 2.00%
Euro Zone: 4.00%
United Kingdom: 5.00%
New Zealand: 8.25%
After reviewing my options its seems pretty clear that if I am just going on interest rates, then New Zealand is the place to put my money as this will earn me an extra 6.25% in interest each year over investing that same money in the United States. Now I am not going to drag the lesson out by including all the history of the interest rates in New Zealand here, but I will tell you they have been in a high interest rate environment relative to the United States for quite some time. With this in mind if I would have have followed this logic in the past then it would have played out very well for me not only from an interest rate standpoint but also, as this chart shows, from a currency appreciation standpoint. Because I would have been investing in New Zealand bonds I would have been holding New Zealand dollars and also benefiting from the large run up in the New Zealand Dollar:
Now obviously hindsight is 20/20 and I have simplified things here for our understanding, but this is not too far off from how international investors including large market moving hedge funds and other players think. It is also a great example of the forces we have spoken about in our lessons on capital flows and in our last lesson on interest rates at play in today's market.
That's our lesson for today. In our next lesson we are going to continue our discussion on how interest rates move the forex market with a look at something which is known as the carry trade, which is also one of the more popular trading strategies in the forex market, so we hope to see you in that lesson.
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All Day flash Mfg PMIs 25-Oct Tue
08:00 DE- IFO
14:00 US- CB Consumer Confidence 26-Oct Wed
All Day flash SVC PMI
00:30 AU- CPI
14:00 US- New Homes Sales
14:00 US- Pending Homes Sales
14:30 US- EIA Crude 27-Oct Thu
08:30 GB- GDP
12:30 US- Weekly Jobs
12:30 US- Durable Goods
23:30 JP- CPI 28-Oct Fri
12:30 US- GDP
14:00 US- University of Michigan 30-Oct Sun
00:00 RZ/GB Clocks turn back one hour
Today has a light data calendar with only key Canadian CPI and Retail Sales data slated.
As expected, the highlight of trade this week has been the Thursday ECB policy board meeting outcome. While the ECB statement included no surprises, markets took the Draghi comments to be dovish. The ECB used its standard rhetoric and said no decision on a "taper" would be announced until the December meeting. Markets reacted by taking out stops above and below the markets in EURUSD.
UK Retail Sales data Thursday were lacklustre, while Australian Employment data for September were weaker than expected.
U.S. Bond yields remain depressed following mixed September CPI data and recent Fed comments. Both the Fed and BOE have started to make it clear that they would ignore an inflation overshoot to get their economies growing again.
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