The forex markets fluctuate daily, and a combination of sentiment, as well as, fundamentals drive the demand for one currency relative to another. The demand is driven by the need to purchase assets in a country which are helped by the strength of the countries underlying economy. The stronger than economy, the more demand there is for its assets, as the perception of growth drives demand. When an economy is strong, it generally experiences elevated interest rates, relative to many of its trading partners. This interest rate differential can influence your trading decisions as it helps drive the direction of a currency pair.
Interest rates are driving by monetary policy which are controlled each county’s central bank. Generally, a central bank meets multiple times per year, and in many situations, will change their position on interest rates. You can track monetary policy decisions and monitor these changes by viewing iforex interest rates. When interest rates change, the differential between two countries interest rates will be altered, making one more attractive relative to the other. This will be immediately captured in the forward forex markets, which could be the driving force behind the forex spot market.
Interest Rate Differentials
The interest rate differential reflects one interest rate divided by another which is then either added or subtracted from the spot price to generate a forward currency price. If you plan on holding a currency pair for more than 2-days, you will have to pay away or receive the forward differential. In many cases this makes holding a currency pair favorable or unattractive which can drive the direction of an exchange rate.
For example, if you purchase the dollar for 2-years, versus the Japanese yen, you will be receiving a benefit for holding the dollar. If the spot price remains unchanged over the 2-year period, you will generate a gain of the difference between the two interest rates. Many investors call this benefit the carry. This carry makes holding the dollar more attractive over the long term, relative to the Yen. This does not mean traders will not take short position against the USD/JPY, but its unattractive to be short the dollar, as you most pay away to hold a long yen position.
You can track the interest rate differential by using a graph. The chart above shows that U.S. treasury versus the Japanese 10-year government bond. The current 2.13 interest rate differential means that the U.S. 10-year is 2.13% greater than the Japanese government bond. This means that if you hold the dollar and invest in the 10-year and borrow the Japanese government rates, you would earn 213 basis points. As the yield differential climbs it makes purchasing the USD and shorting the JPY more attractive.
Discounted Cash Flows
Higher interest rates can also influence stock prices. The value of a stock is the discounted cash flows of its revenue stream. If rates move higher the present value of the cash flows moves lower, making the value of the stock less attractive. Interest rates can influence nearly all assets, including the forex market, stocks and commodities. By changing the interest rate differential, and altering discounted cash flows, it’s important to track interest rates, to see the headwinds and tailwinds the capital markets face.