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How Interest Rates Affect Your Trading Strategy

Interest rates are an intricate part of the capital markets playing a crucial role in determining the future direction of many different types of securities. Whether you are trading forex or stocks, or debt or indices, interest rates can play an important role in determining the future direction of a market. Changes to interest rates can alter the direction of a security and can directly affect your trading strategy.

When you think about interest rates as they pertain to the capital markets, sovereign interest rates are the most pertinent. Whether you have owned a bank certificate of deposit, or a municipal bond, these interest rates are driven by the monetary policy of your country or monetary union.  Sovereign rates refer to the overnight bank lending rate that is dictated by a central bank such as the Federal Reserve, the Bank of Japan or the European Central Bank.

If you trading strategy is focused on trading interest rates or forex, then changes to interest rates greatly affect your trading strategy. An interest rate announcement that is made when a central banks meets to determine monetary policy, is a key data point that is worth paying attention to.

Interest Rate Differentials

When you trade the forex markets, it is important to pay attention to the difference between each currencies interest rate.  Interest rates play an important role in driving the direction of the forex markets.  This happens because the forward curve in the forex market is made up of two specific interest rates.  If you want to hold a currency pair for a period that is longer than 2-business days, which is referred to as the spot rate, you need to transact in the forward market.  For every day you hold a currency pair longer than spot, you will either receive the difference in the interest rate differential or pay away that difference.

For example, when evaluating the USD/JPY, U.S. short term and long term rates are higher than Japanese rates. This means if you plan on holding the USD/JPY you will receive the difference and if you are short this currency pair, you will have to pay away this differential.  As the differential gets larger, it becomes less attractive to own the lower yielding currency.

The forex markets tend to move in the direction of an interest rate differential. In the chart of the USD/JPY and the US 10-year Treasury versus the Japanese 10-year government bond, you can see the interest rate differential and the currency pair move in tandem. A change in long term interest rates driven by a change in monetary policy will alter the course of the interest rate differential which will change the path of the currency pair.

Present Value of Future Cash Flows

Interest rates also have an effect on stocks and indices. The price of a stock is the present value of future cash flows of a company.  As interest rates rise, these cash flows become less valuable. As interest rates fall, these future cash flows become more valuable.

Interest rates play a key role in determining the direction of many capital market securities.  If you plan on trading these instruments it’s important to understand how interest rates can affect your trading strategy.

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