Forex Fundamental Analysis Beginners Course 1 – Interest Rates
What are Interest Rates?
In this first course we will look at perhaps the most important of all fundamental indicators: Interest Rates.
Interest rates are the rates at which a lender is willing to lend his money to the borrower and the rate at which an investor can get a return in the market. Interest rates can also be seen as the price of cash as the money could have been invested instead.
Let’s take a look at the very basics of interest rates are set and how they determine currency rates, which is what we are really interested in. In a free market, all prices are set by the forces of supply and demand as illustrated by this graph:
How Are Interest Rates Set?
Natural interest rates are very important in an economy because they make sure that people who have money to invest can find something to invest in. In our free market theory, interest rates are determined purely by demand and supply. In reality interest rates are more or less set by the Central Banks of the world such as the Federal Reserve in the US. The central banks around the world are autonomous institutions which have been given the right to print money and act as a lender of last resort to commercial baks. Essentially, these 8 major Central Banks around the world, set the interest rates for the market. As forex traders we are interested in predicting which rates the central banks will set in the future, so we can either buy or sell forex pairs based on these predictions.
Central banks generally have two goals:
To limit inflation and to stimulate growth. Because this is widely known, forex traders then study other economic indicators to predict how the central banks will act on this informations. The most important indicators to look at are:
- CPI (Consumer Price Index)
The CPI is a measure of the general price level and thus of inflation. A growth in prices means inflation. Rising inflation could indicate that the central bank will raise interest rates.
- Consumer Spending
Consumer spending shows the consumers trust in the market. If consumer spending is falling, the central bank may react by lowering interest rates.
- Employment Levels
Employment levels are a very good measure of the general health of an economy. Rising unemployment may cause the central bank to lower rates to stimulate growth.
How Does Interest Rates Affect The Price of a Currency?
The relationship between interest rates and a nations currency are as follows:
Rising Interest Rates -> Positive Impact on Currency Price
Falling Interest Rates -> Negative Impact on Currency Price
The reasoning behind this is as follows:
Rising Interest Rates
When interest rates in a country rise, it becomes more profitable to invest in that country. Because of this, there is an increased demand of local currency to invest, which drives prices upwards. It also becomes less attractive to borrow money in that currency, which limits the supply of that currency. The net result is less supply and more demand, which equals higher price.
Falling Interest Rates
The reverse is true when interest rates fall. It becomes less profitable to invest in that country which means demand for that currency declines. Again, we have the other effect as well, which is that it becomes cheaper to borrow, which expands the supply of the currency. Falling demand and rising supply means lower price.
Conclusion
Interest rates are very important in fundamental analysis. Particularly the release of data from the central banks should be followed closely as they eventually are the ones to set interest rates.
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