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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WEEKLY HIGH IMPACT NEWS: 9-Dec Fri
02:00 CN- CPI
09:30 GB- Trade
15:00 US- University of Michigan Survey
No Major Data 13-Dec Tue
09:30 GB- CPI/RPI 14-Dec Wed
09:30 GB- Employment
13:30 US- Retail Sales
13:30 US- PPI
14:15 US- Industrial Production
15:30 US- Crude Oil
18:00 US- FOMC Decision 15-Dec Thu
00:00 All-Day- flash PMIs
00:30 AU- Employment
08:30 CH- SNB Decision
09:30 GB- Retail Sales
10:00 DE- ZEW Survey
12:00 GB- Bank of England Decision
13:30 US- CPI
13:30 US- Current Account
13:30 US- Weekly Jobless 16-Dec Fri
10:00 EZ- final HICP
13:30 Housing Starts/Permits
No matter what you call it, the ECB announced a "taper" of its asset purchases to EUR 60b per mo from EUR80b starting in April 2017. Even though President Draghi claimed it was not a "taper" but it generated a "taper tantrum" in EURUSD. I warned Thursday would be a volatile day, but it exceeded my expectations.
The calendar is light today. Better than expected U.K. trade data has been a market-mover for the GBP. University of Michigan preliminary Sentiment data for December are due later. A positive "Trump Effect" would not surprise.
We remain confident that the Fed will raise rates by 25bps next Wednesday. Monthly Job statistics and inflation are the two top items on which the FOMC monetary bases its policy decisions.
The U.S. Presidential vote recount continues. Odds for a reversal of the Trump victory are slim.
looking for your first broker or do you need of a new one? There are
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