How interest rate decisions create trade setups in forex

The interest rate is one of the most crucial factors driving forex trade. For those unaware, this is the rate at which the domestic bank is willing to pay interest on retail savings. Considering all other factors that can affect the value of a currency remain constant, the interest rate is directly proportional to the value of the domestic currency.

Taking the pound from the UK as an example, its value should increase when the bank's interest in the UK increases. Higher interest rates will attract more people from outside the UK who will rush to deposit money in the banks there. As the demand for pounds vis-à-vis other currencies increases, the domestic currency, GBP in this case, rises.

The highest demand for one currency means a rise in its value. However, the relationship between currency value and interest rate is not straightforward. Here are a few things to keep in mind when making forex trade decisions based on interest rate as an indicator.

NOTE: Forex investments involve significant risk. Do not take the views mentioned here as financial advice. Please conduct thorough research before making any investment.

Things to keep in mind when using interest rates in forex trade

The expected vs the actual rate of interest announced

It is not that the direct correlation between the interest rate and currency always holds. At times, the expected interest and the actual rate announced matter. For instance, if the people were expecting an interest rate rise by two hundred basis points and the actual rise that happens is only one hundred basis points, then the currency’s value is likely to fall. In this case, the trading and the effects on the price are effective mostly as a speculation rather than any actual result.

Hence, it makes sense to segregate the interest rate and its effects into three stages.

Pre-announcement stage

At this stage, it is best to analyze the other macroeconomic data points, like the inflation data. Then, take into account opinions by central banks to gauge the mood before the interest rates are declared.

Events that trigger volatility

Events like declaration of war or major election losses trigger a season of volatility. Traders focus on key technical levels before the announcement, aiming to catch momentum once volatility expands.

Long-term trends

The spike in value after an interest decision. When the rate of interest is high, there may be a transient high, which may make a U-turn after the hype settles in. So, it is best to keep a track of long-term trends after the interest rate declaration.

Knowing how the interest rate affects the timing, direction, and conviction rates of forex trade is crucial for any trader, new or experienced.

Edited by Abu Amjad Khan