Every currency appearing on the Forex dashboard relates to a country, or to a group of countries as in the case of the Euro (the Euro is the common currency for nineteen European nations). A currency’s value depends on the strength of that country’s economy. A rule of thumb is that there is often a direct correlation between economic strength and currency strength. As the Forex dashboard shows, the value of currencies fluctuates against each other. These fluctuations may represent economies entering various stages of their economic cycle i.e. recession or boom, but also may be due to the respective country’s interest rate levels.

The interest rate sets the value of a currency. Central banks set the interest rates and the bigger the difference in interest rates between two currencies, the more appealing the currency with the higher rate is to investors. In other words, everyone typically wants to own a currency that pays a higher interest rate. This is what moves the currency market, as investors try to interpret the economic data released every day to form an idea about what the central banks will do in the future with the interest rate level.

How Central Banks use interest rates

Central banks around the world meet on a regular basis, either monthly or every six weeks. They evaluate the shape of an economy and set the interest rate level. For currency, the higher the rate, the better. Investors tend to go long or to buy a currency pair when the central bank hikes or raises the interest rate. Why? When the economy grows, inflation tends to grow too. Because price stability is the concern of any central bank, it will raise the interest rate level. This effectively stimulates commercial banks to stop lending to businesses and the general population. Instead, the central bank pays an interest rate to overnight deposits made by commercial banks. This is how central banks drain liquidity. Or, tighten the monetary policy. Commercial banks often have excess liquidity which is expensive to keep. They will buy the local currency and make overnight deposits to the central bank’s facilities. Thus, the buying pressure will push the value of the currency higher.

An opposite reaction happens when the economy enters a recession. Central banks act by easing monetary conditions. To start with, they lower the interest rate. Thus, commercial banks don’t find any incentive in making deposits to overnight facilities. Instead, they’re willing to take the risk of investing in the real economy, flooding the economy with money. While the money supply increases, the currency’s value will fall against other currencies that pay a higher interest rate.

Understanding these relationships helps currency investors anticipate interest rate moves. In the end, this is what Forex trading is: a game of probabilities. The key question is, what are the chances for a central bank to hike or cut the interest rate level? If investors solve this puzzle, they will know if a currency will appreciate it or not.

Take-aways:

  • Every currency has a central bank.
  • Central banks set the interest rate of a currency based on economic performance.
  • Investors buy and sell currencies or currency pairs, interpreting economic data and anticipating what central banks will do with the interest rates.
  • There is a direct relationship between interest rates and the value of a currency: the higher the interest rate, the stronger the currency.

HYCM Lab is a financial analysis source that provides regular insights on how global news affects the markets including forex, commodities, stocks, indices, and cryptocurrencies*. Run by the HYCM team, it equips traders with everything needed to make informed trading decisions.