In the global economy, it goes without saying that all types of economic marketplaces are interconnected. Often, a rally or decline in the stock market will affect the bond market, and vice-versa, as money is shuffled back and forth between equities and bonds. For example, investors pulling their money out of a bear market need somewhere else to put it, and often this excess capital winds up purchasing corporate or municipal debt. Likewise, real estate values can be affected by inflation when the Federal Reserve Board raises or lowers interest rates to combat a rise or fall in consumer prices. When interest rates go higher, home buyers are able to afford less, which sends prices south. Another marketplace that interest rates can affect is the forex, or Foreign Exchange Market.
The main way that interest rates in the United States economy can affect the forex market is by helping to funnel money in and out of foreign investments. When interest rates are low, investors that are looking for a safer alternative than equities often turn to foreign investments such as the bond markets of other countries. For example, when the stock market crashed in 2000, most investors shifted their focus from trying to maximize their returns to preserving capital. The logical place to turn in this case was the government bond market, but interest rates were hovering around two percent and were headed even further down. Australia, however, was offering government debt with an interest rate of around five percent, and the risk was about the same as that of U.S. bonds, so naturally a lot of money flowed into that country to buy bonds in the denomination of the Australian dollar. When a large amount of money is shifted from one currency to another, it affects their prices due to a shift in supply and demand.
This discrepancy in interest rates between countries led to an investment strategy called the “carry trade”. In this approach, a person borrows money in a currency that has a low interest rate and converts it into the denomination of a country that currently pays a high interest rate on bonds. The investor then buys bonds with the new currency, and collects the difference between the amount of interest received from the bonds and the amount of interest paid to the bank from which the money was originally borrowed. This strategy can be very lucrative as long as the exchange rate stays constant, but as it can be difficult and expensive for the average individual to transfer money to different countries, it is best attempted by large institutions such as hedge funds and investment banks.
But the individual investor can take advantage of these discrepancies, also known as “yield spreads”, by observing patterns in currency prices that are created by interest rate changes. As prices are affected by the flow of money into and out of a currency, the knowledge of a situation that is favorable for a carry trade can tell the investor where the institutional money is likely to go, which will ultimately raise the price of the target currency. As many a forex trader can attest, the price of a currency relative to another is often directly related to the difference between the interest rates of the two countries. Using the example of Australia and the United States, if one plots the value of the Australian dollar in U.S. dollars over the course of several years, along with the yield spread during that time, the two lines on the chart are almost mirror images of one another.
By paying attention to interest rate changes in the global economy, the forex investor can better arm himself in making trading decisions. As the yield spread is usually an indicator of one currency’s price relative to another, if one has an idea where interest rates are headed, he can often predict the rise and fall of forex prices.
The main way that interest rates in the United States economy can affect the forex market is by helping to funnel money in and out of foreign investments. When interest rates are low, investors that are looking for a safer alternative than equities often turn to foreign investments such as the bond markets of other countries. For example, when the stock market crashed in 2000, most investors shifted their focus from trying to maximize their returns to preserving capital. The logical place to turn in this case was the government bond market, but interest rates were hovering around two percent and were headed even further down. Australia, however, was offering government debt with an interest rate of around five percent, and the risk was about the same as that of U.S. bonds, so naturally a lot of money flowed into that country to buy bonds in the denomination of the Australian dollar. When a large amount of money is shifted from one currency to another, it affects their prices due to a shift in supply and demand.
This discrepancy in interest rates between countries led to an investment strategy called the “carry trade”. In this approach, a person borrows money in a currency that has a low interest rate and converts it into the denomination of a country that currently pays a high interest rate on bonds. The investor then buys bonds with the new currency, and collects the difference between the amount of interest received from the bonds and the amount of interest paid to the bank from which the money was originally borrowed. This strategy can be very lucrative as long as the exchange rate stays constant, but as it can be difficult and expensive for the average individual to transfer money to different countries, it is best attempted by large institutions such as hedge funds and investment banks.
By paying attention to interest rate changes in the global economy, the forex investor can better arm himself in making trading decisions. As the yield spread is usually an indicator of one currency’s price relative to another, if one has an idea where interest rates are headed, he can often predict the rise and fall of forex prices.
Forex is simple follow the trend and you will rich.
