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Inflation and Interest Rates: Unveiling Their Impacts in Forex Trading

TABLE OF CONTENTS

Inflation and Interest Rates: Unveiling Their Impacts in Forex Trading

Inflation and Interest Rates: Unveiling Their Impacts in Forex Trading

Vantage Updated Updated Fri, 2024 May 10 06:36

Forex, or foreign exchange, refers to the exchange of one currency for another. This is an important function in the global economy as it facilitates the fair exchange of value between different countries. Without the forex market, it would be impossible for international trade and cross-border tourism to take place. 

As different currencies have different values relative to each other, parties exchanging currencies refer to the exchange rate, which is derived from the forex markets. Since they are essentially a measure of one currency’s value against another, exchange rates rarely stay fixed, and instead tend to fluctuate throughout the trading day. 

Changes in the exchange rate is at the core of forex trading, which is where traders attempt to generate profits from the forex markets by buying and selling pairs of currencies. Specifically, it is the degree and rate of change in value between two currencies that creates the potential for profits (and losses).  

As such, it is important to understand the reasons why a currency may rise or fall in value against another, so as to identify upcoming trading opportunities and increase the likelihood of making a favourable trade. 

In this article we will be exploring the two biggest drivers of exchange rate fluctuations. Whether you’re a beginner in forex trading seeking a foundation understanding of currency behaviour, or an experienced forex investor looking to deepen understanding of forex market complexities, read on to discover how inflation and interest rates impact the forex markets. 

Key Points

  • Inflation and interest rates are critical macroeconomic factors that directly influence the value of currencies in forex trading.
  • Central banks manage inflation by adjusting interest rates, which in turn affects currency values and forex market dynamics.
  • Understanding the relationship between inflation, interest rates, and forex trading can enhance trading strategies and improve prediction accuracy in market movements.

Understanding Inflation and Interest Rates

Inflation and interest rates are macroeconomic factors that have an immediate impact on the value of currencies. But before we can discuss how and why, it is important to first understand what each of these terms mean.

Inflation Explained [1,2]

Inflation describes the phenomenon of prices increasing over time. While prices increasing also mean an erosion of purchasing power, inflation is generally accepted as normal in a growing economy. Modern economists believe that growing prices help to drive economic growth and act as a buffer against falling prices.

Economic growth is a closely intertwined dance between profits and spending. When businesses make profits, they spend part of those profits to pay wages. Employees use wages to make purchases, driving consumption and contributing to company profits. With higher consumption, businesses are able to raise prices for more profits, which gets passed to employees as higher wages. In this way, the economic growth cycle continues. 

If inflation is too high, and prices rise too much, consumption tends to fall. This means companies earn less profits and produce less wages, interrupting economic growth. 

If inflation falls too low (which means prices are growing too slowly, or not at all),  or becomes negative (deflation, where prices start falling), economic growth also cannot be sustained. 

Therefore, to be effective, inflation needs to be kept at a slow and steady rate. To that end, the US Federal Reserve strives to keep inflation at around 2% per year. 

Officially, inflation is measured through a series of indicators. Some of the main ones include:

  • Consumer Price Index (CPI): This is a measurement of the percentage change in the price of a basket of goods and services commonly consumed by households. CPI is also known as “headline inflation” [3]
  • Producer Price Index (PPI): This tracks the average change over time in the selling prices received by domestic producers for their output. Often regarded as a precursor to the CP, as it tracks prices before they reach the consumer [4]
  • Core Inflation: This inflation measure is similar to CPI, but excludes the cost of food, energy, and any CPI components that can exhibit large amounts of volatile from month to month, thus skewing the overall reading [5].

Bank Interest Rates Explained [6]

A bank interest rate refers to the interest charged by a nation’s central bank on loans made to domestic banks. Central banks make adjustments to interest rates as a means to influence economic growth, making interest rates an important part of a nation’s monetary policy. 

In short, when interest rates are raised, the cost of borrowing increases, as does interest earned on savings accounts. This incentivises consumers to cut back spending and start saving more, which has a slowing effect on the economy. 

In contrast, when central bank interest rates are lowered, the cost of borrowing falls, while savings accounts slash their interest rates. This encourages consumers to spend more and save less, putting more money into the economy and stimulating economic growth. 

How are Inflation and Interest Rates Related?

Central banks use interest rates to control inflation. When inflation becomes too high, central banks raise interest rates to reduce the flow of money in the economy and disincentivize borrowing by making loans more costly. 

The aim is to slow the economy down and allow prices to go back to levels that are more reflective of fair value. As the costs of goods fall, inflation starts dropping until it approaches a desired level as determined by the central bank. 

As you might realise, altering interest rates is a delicate operation, and it may take several changes made before the desired level of inflation is achieved. 

Raising rates too high and too fast can cause an economic crash, as struggling businesses shutter and jobs are lost. 

However, not raising rates sufficiently or quickly enough can result in hyperinflation. This is when prices skyrocket, with extreme inflation eroding the purchasing power of a country’s currency to render it practically worthless – as was most recently seen in Turkey [7].

Impact of Inflation on Forex Trading

Now that we know how inflation can affect an economy, let’s turn our discussion to the impact of inflation on forex trading. What happens when inflation is high or low, and how does it affect the exchange rate between a pair of currencies? 

High Inflation and Forex Trading

In general, when an economy experiences high inflation, the purchasing power of its currency is reduced. Goods and services become more expensive, and investors are turned away from doing business. 

Thus, high inflation can cause a currency to fall in value against its counterparts, which potentially favours taking short positions in the relevant currency pair. 

However, note that forex trading always involves two currencies, so it is not enough to focus only on conditions that may only impact one currency. You should also check the counterpart currency to ensure your trading thesis is valid. 

Low Inflation and Forex Trading

In general, when an economy experiences a stretch of low inflation, its currency tends to strengthen, as more money flows into the country. The currency becomes more valuable as its purchasing power increases, improving its exchange rate.

Correspondingly, low inflation can help a currency appreciate in value against its counterpart in a currency pair. This opens opportunities for forex traders to potentially benefit from long positions in the pair. 

How Inflation has Impacted the USD/EUR Pair

Following the COVID-19 pandemic, both the US and the Eurozone saw inflation rates rising  towards the end of 2022. In November 2021, the Harmonised Index of Consumer Prices (HICP) reached nearly 8% for the US, and almost 5% of the Eurozone [8].

Based on what we’ve discussed thus far, you’d expect the Dollar to fall in value against the Euro, owing to the higher rate of inflation seen in the US. 

However, this was not the case; on Nov 2021, the US Dollar in fact traded close to a 16-month high against the Euro. This was attributed to growing fears in the Eurozone due to a surge in COVID-19 infections, threatening renewed lockdowns [9]

Here, we see that market sentiment overrode the theory that higher inflation would cause currency devaluation, an important reminder that the forex markets don’t always act according to theory. 

Learn all about EUR/USD currency pairs with our comprehensive guide.

Impact of Interest Rates on Forex Trading

Recall that interest rates can also have a significant impact on forex currency pairs. In this section we will discuss the effect of high and low interest rates on currencies. 

Once again, bear in mind that inflation and interest rates aren’t the only factors that have a bearing on the forex market. In reality, there are multiple intertwining and complex factors that come into play and it is not always possible to map them out completely.

Higher Interest Rates and Forex Markets [10]

Generally, when interest rates increase, this pushes up the value of the corresponding currency, due to heightened demand from foreign investors. This is because foreign investors who invest in the currency (by buying government bonds, for instance) stand to receive a higher rate of return, compared to investing in other currencies. 

The rise in value positively impacts the currency’s exchange rate, which affects the price of relevant currency pairs. Hence, if an interest rate increase is on the horizon, this could potentially indicate a forex trading opportunity featuring long positions.

Lower Interest Rates and Forex Markets [11]

If rising interest rates tend to cause a currency to appreciate in value, what happens when a central bank cuts interest rates instead?

Well, in most cases, cutting the interest rate results in a devaluation of the relevant currency. This is because foreign investors can no longer receive high returns, and thus turn away in favour of a currency with higher interest rates. 

Interest rate cuts also encourage borrowing and spending, which can cause upwards pressure on inflation metrics, and potentially weaken the currency in turn. 

How Interest Rates Influenced the EUR/USD [12]

In March 2024, weaker-than-expected unemployment and wage gain data kept an anticipated U.S. Fed wage cut on the table. In response, the Dollar slipped against the Euro, falling by 0.07% to hand the EUR an eight-week high.

The softening of the Dollar was in line with expectations, as currencies typically weaken after central bank rate cuts. However in this case, the dip occurred even though no rate cuts had been announced; Chairman Powell had merely stated that the Fed was close to having the confidence it needed to cut rates. 

This demonstrates how volatile the forex market can be, and it is not unusual for traders to make moves in anticipation of actual events. 

Predicting Forex Market Movements in a Complex Landscape [13,14]

Learning how inflation and interest rates can influence forex trading is undoubtedly helpful in understanding the market. While we’ve tried to lay out the connections between inflation, interest rates and currency exchange rates, it’s important to realise there are many more factors in play. This makes trying to predict forex market movements a complicated task. 

Here are some other factors that may influence the forex markets, and bear investigation as you plan your own forex trades. 

Analysts Forecast

Because interest rate moves can have far-reaching consequences, banks, brokerages and forex analysts regularly put out forecasts and consensus estimates. This can create a sort of self-fulfilling prophecy, where the market is seen to behave as predicted. 

However, analysts’ forecasts can allow forex traders to gauge the likelihood of interest rate changes. This simply entails choosing four or five analysts that have a good track record, and paying attention to their estimates and forecasts to help you spot potential trading opportunities, and decide what trades to make. 

Global Trade

A country’s balance of trade can also be a significant factor in determining the value of a currency. This is because greater demand for a country’s product also means greater demand for its currency, which can affect exchange rates. 

For this reason, forex traders should pay attention to the surplus/deficit between economies relevant to the currencies they are looking to trade. Furthermore, trade figures can help clarify the reasons for a currency’s strength or lack thereof. 

Level of Debt

A country’s debt levels can act as an indicator of impending currency collapse. While high levels of debt is typically manageable, especially for advanced economies, the imbalance may eventually lead to higher inflation rates. This may cause interest rates to be raised, triggering a devaluation of the country’s currency. 

Monetary Policy

Interest rates are determined by monetary policy, which is traditionally described as hawkish or dovish. A hawkish monetary policy means the central bank is looking to reduce or control inflation, while a dovish monetary policy indicates there is higher tolerance for the currency inflation levels.

Since monetary policy directly affects interest rates (and by extension, currency exchange rates) paying attention to the tone of the monetary policy is important. Central banks often hint at their policy direction in advance, offering opportunities to get ready for ensuing changes.

Inflation, Interest Rates and Forex Trading Strategies 

We’ve seen how inflation and interest rates can influence the forex markets. In reality, the forex markets are governed by far more than just these two factors, and traders need to take a broad range of data and information into account. 

For instance, in 2022, the United States experienced high inflation following the COVID-19 pandemic. High inflation means high prices, which means the Dollar should depreciate in value, correct? In fact, the opposite happened, and USD appreciated as much as 12% [15].

Why did this happen? The reason is not because the US Federal Reserve raised interest rates. Rather it was the consistently hawkish stance taken by the Fed that carried on raising interest rates even in the face of alarming signs such as bank collapses [16]

At the end of the day, it was the determination displayed by the Fed – which the market took as a sign of confidence – that resulted in the Dollar gaining in strength when theory says it should weaken. 

Things could have gone the other way too. If the market had believed the Fed was going too far, and the US economy would be driven into a recession, investors may have dumped the USD in favour of another safe haven asset, such as gold. This would have caused the Dollar to fall. 

Read our article to better understand how gold prices react to interest rates, monetary policies, and dollar values.

This recent, real-life example once again behoves us not to underestimate the complexity of the forex markets. With that in mind, let’s discuss some popular forex strategies within the context of inflation and interest rates. 

Carry Trade [17]

A currency carry trade is a simple and well-known forex trading strategy. It involves borrowing a currency with a lower interest rate to fund the purchase of a currency with a higher yield. This allows the trader to capture the difference between the two rates, which can be substantial, depending on the currency pair chosen. 

Currently the AUD/JPY pair is a popular candidate for carry trade strategies. This is because the AUD has among the highest yield, while the JPY is offering among the lowest. 

When done correctly, a carry trade can provide traders with both capital appreciation and interest revenue. Carry trades work well when central banks are increasing rates, or have places to increase them. The key is to get in at the beginning of the rate increase, and not after. 

Note that intervention from central banks to stop a currency or rising falling could thwart the carry trade and quickly reverse gains. 

Position Trading [18]

Position trading ignores short-term swings in favour of potentially profiting from larger, long-term trends. Considered one of the longest-term strategies in forex trading, position trading entails holding positions as long as several weeks to years. 

While currencies may not experience dramatic rallies the way company stocks could, there is still considerable potential for profit with position trading in forex, given the common use of leverage with high limits. 

Finding success with position trading revolves around understanding the long-term fundamentals of the currencies you are trading. This means paying attention to political, economic and geographical news that affect the underlying countries. 

In particular, tracking inflation trends and interest rate patterns is essential. By building an awareness of how a country tends to respond at various points of the economic cycle, a forex position trader will be better able to determine appropriate points at which to enter or exit trades. 

Day Trading [19]

The fast-paced, round-the-clock nature of the forex markets make them highly suited to day trading. This is a widespread trading strategy that focuses on short-term trades spanning hours to less than a day. Day traders do not keep positions open past 24 hours, so as to avoid overnight risk. 

In terms of inflation and interest rate, day traders should be vigilant around days when economic reports are slated for announcement. This is because unexpected or dramatic results can cause wild swings in the price of currency pairs, which day traders do not have the luxury of riding out. 

Day traders should consider making use of an economic calendar to keep track of important announcements and better plan their trades. 

Importance of Risk Management in Forex Trading

By this point, hopefully we’ve impressed upon you the complicated nature of the foreign exchange markets, and how forex traders should not take things for granted. Employing proper risk management strategies is always essential, but perhaps more so in forex trading, given the more advanced nature of the subject. 

Consider the following tips to manage risk when trading forex.

Have a Trading Journal

Earlier, we mentioned using an economic calendar to help you keep track of important dates. As an extension of that idea, try starting a forex trading journal to help you track and analyse your trading outcomes. 

You should note down the trade you made, its outcome, and why it succeeded or failed. This will prompt you to uncover your blindspots, while helping you understand what information you should pay attention to. 

Stick to Appropriately Sized Trade 

This is the essence of risk management. Recognise that no matter how accurate your information is and how well-prepared you are, the forex market can always flip the script on you – as we’ve discussed twice earlier in this article.

Therefore, always control the size of your trade, no matter your level of conviction. What you want is to build a series of multiple wins, instead of risk blowing up your account each time you trade.  

Consider Staying Away During High Volatility

It’s perfectly ok to temporarily refrain from trading if you are uncomfortable about the state of the market. If you’re unsure what to do when economic data such as inflation levels, unemployment and GDP forecasts are at odds with monetary policy and interest rate expectations, you can pause trading until clarity emerges. 

The forex markets are essential to the lifeblood of the world economy, which means disruptions or fuzziness are likely to sort themselves out before long. Afterall, if there’s one all forex traders can agree on, it is that markets hate uncertainty. 

Key Takeaways

The forex markets certainly hold much allure for traders, offering round-the-clock trading, deep liquidity, and a selection of popular currencies to trade. It is also highly complex, being influenced by inflation, interest rates and other important economic factors. 

This isn’t surprising; after all we’re dealing with the interactions between different currencies, and the unique conditions that drive them. This is why forex traders should invest time to understand and become familiar with geopolitical and macroeconomic events, and how they impact the countries of currencies they wish to trade. 

Learning forex trading is not exactly a walk in the park, especially if you’re unfamiliar with economics and the global financial system. But keep at it and you’ll soon find your efforts rewarded. 

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References

  1. “Inflation: What Is It? How It Can Be Controlled And Extreme Examples – Investopedia”. https://www.investopedia.com/terms/i/inflation.asp. Accessed 30 April 2024.
  2. “When Is Inflation Good for the Economy? – Investopedia”. https://www.investopedia.com/ask/answers/111414/how-can-inflation-be-good-economy.asp. Accessed 30 April 2024.
  3. “Inflation and its Measurement – Reserve Bank of Australia”. https://www.rba.gov.au/education/resources/explainers/inflation-and-its-measurement.html. Accessed 30 April 2024.
  4. “Predict Inflation With the Producer Price Index (PPI) – Investopedia”. https://www.investopedia.com/articles/economics/11/breaking-down-producers-price-index.asp. Accessed 30 April 2024.
  5. “What Is Headline Inflation (Reported in Consumer Price Index)? – Investopedia”. https://www.investopedia.com/terms/h/headline-inflation.asp. Accessed 30 April 2024.
  6. “Bank Rate: Definition, How It Works, Types, and Example – Investopedia”. https://www.investopedia.com/terms/b/bankrate.asp. Accessed 30 April 2024.
  7. “What Inflation Feels Like in Real Life: the Case of Turkey – Gold Avenue”. https://www.goldavenue.com/en/blog/newsletter-precious-metals-spotlight/what-inflation-feels-like-in-real-life-the-case-of-turkey. Accessed 30 April 2024.
  8. “Are Inflation Dynamics Different In The Euro Area, And The United States? – European Parliament”. https://www.europarl.europa.eu/RegData/etudes/IDAN/2023/755706/IPOL_IDA(2023)755706_EN.pdf. Accessed 30 April 2024.
  9. “Dollar shines, euro suffers as COVID fears flare over Europe – Reuters”. https://www.reuters.com/markets/us/dollar-shines-euro-suffers-covid-fears-flare-over-europe-2021-11-22/. Accessed 30 April 2024.
  10. “How Do Interest Rates Affect Exchange Rates? – Bound”. https://www.bound.co/blog/how-do-interest-rates-affect-exchange-rates. Accessed 30 April 2024.
  11. “Why Interest Rates Matter to Forex Traders – Babypips”. https://www.babypips.com/learn/forex/interest-rates-101. Accessed 30 April 2024.
  12. “US dollar slips as data keeps rate cut hopes intact – The Business Times”. https://www.businesstimes.com.sg/companies-markets/capital-markets-currencies/us-dollar-slips-data-keeps-rate-cut-hopes-intact. Accessed 30 April 2024.
  13. “Why Interest Rates Matter for Forex Traders – Investopedia”. https://www.investopedia.com/articles/forex/08/interest-rates.asp. Accessed 30 April 2024.
  14. “How National Interest Rates Affect Currency Values and Exchange Rates – Investopedia”. https://www.investopedia.com/ask/answers/040315/how-do-changes-national-interest-rates-affect-currencys-value-and-exchange-rate.asp. Accessed 30 April 2024.
  15. “Inflation and Forex: The Role of Inflation in Forex Trading – Benzinga”. https://www.benzinga.com/money/inflation-and-forex. Accessed 2 May 2024.
  16. “Silicon Valley Bank collapse explained: What you need to know – TechTarget”. https://www.techtarget.com/whatis/feature/Silicon-Valley-Bank-collapse-explained-What-you-need-to-know. Accessed 30 April 2024.
  17. “Currency Carry Trades 101 – Investopedia”. https://www.investopedia.com/articles/forex/07/carry_trade.asp. Accessed 30 April 2024.
  18. “Position Trading – Babypips”. https://www.babypips.com/learn/forex/position-trader. Accessed 30 April 2024.
  19. “Day Trading – Babypips”. https://www.babypips.com/learn/forex/day-trading. Accessed 30 April 2024.
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