How do changes in interest rates affect the foreign exchange market?

Interest rates are one of the most influential factors in the foreign exchange market, shaping currency value and driving trader decisions. When the central bank adjusts interest rates, it will trigger a chain reaction in the global market. Understanding how these changes affect currency volatility is crucial for forex traders who want to stay ahead of market trends.

What happens when interest rates rise?

When the central bank raises interest rates, it indicates confidence in the health of the economy. Higher interest rates attract foreign investors seeking better returns on fixed income assets such as bonds. As the demand for domestic currency increases to purchase these assets, the currency usually appreciates.

For example, if the US Federal Reserve raises interest rates, the US dollar (USD) typically appreciates relative to other currencies. Traders expect higher returns on US investments, thereby increasing demand for the US dollar. This situation provides traders with the opportunity to long the US dollar in the face of weak currencies.

However, higher interest rates also increase borrowing costs, which may slow down consumer spending and business investment. Traders must evaluate whether the economic environment can maintain higher interest rates without suppressing growth.

What happens when interest rates decrease?

On the contrary, when the central bank lowers interest rates, it is usually to stimulate economic activity. Lower interest rates make borrowing cheaper, encouraging business expansion and consumer spending. Although this can support economic growth, it often weakens the local currency.

Lowering interest rates has reduced the attractiveness of foreign investors to the currency. For example, if the European Central Bank (ECB) cuts interest rates, the Euro (EUR) may depreciate relative to strong currencies such as the US dollar. Traders usually take advantage of this opportunity to short the euro, expecting it to further decline.

In addition, lower interest rates may lead to higher inflation, thereby eroding the purchasing power of currency over time. Foreign exchange traders must closely monitor economic indicators such as inflation rates and GDP growth to assess how the low interest rate environment may evolve.

Factors affecting changes in interest rates

Central bank announcements, economic data releases, and geopolitical developments play a crucial role in shaping interest rate expectations. Economic calendars and other tools help traders track key events such as interest rate decisions, inflation reports, and employment data.

Traders usually plan ahead of expected interest rate changes. For example, if market analysts generally expect the Bank of England (BoE) to raise interest rates, the pound sterling (GBP) may appreciate before the official announcement. This phenomenon is called 'advance pricing', emphasizing the importance of staying informed and responding quickly to news.