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Interest Rates and the Forex: Attention Carry Traders - Watch Those Interest Rates!

Apr 4, 2008
The national interest rate report is one of the five most important economic reports to the Forex market that is released by the government. In the United States this is the Fed Funds Rate, and is by far and away the most important interest rate when considering the impact it will have on the US Dollar in the Forex market.

This rate is the rate that banks and other similar institutions charge each other for over night loans. Often the interest rate will be changed when the governing body hopes to have a specific impact on some part of the economy. Often times when a government wants to "jump start" an economy, they will cut the interest rate.

Interest rates have a very direct effect on the Forex market. An increase in interest rates encourages traders to invest in that nation's market and also causes the demand for currency to rise.

As the demand for a currency rises, traders are willing to pay more and more for the currency, causing that currency to rise in value. The higher interest rates will also attract Forex traders who love to practice the carry trade, since a higher interest rate there will mean more day to day appreciation on their money.

A fall in interest rates will also affect the Forex market. In general, a fall in interest rates will discourage traders from investing in that economy since the return on investment is smaller, and this can have a cumulative effect as carry traders look for a more profitable interest rate on other currency pairs. Usually this means the currency will decline in value.

Part of the reason this especially affects currency value is because many Forex traders love the carry trade, in which they earn interest on a long term trade. A change in interest rates can cause Forex traders to flee to (or from) a currency pair, affecting the value of both.

Any time there is going to be an announcement regarding a change in interest rates, you should definitely pay attention. Each nation usually has a set time when they make such announcements, and will let traders and investors know ahead of time that a change of some kind is coming.

Every change is worth paying attention to, because it is definitely going to affect the market in the short term, and maybe even long term.

Watching the interest rate fluctuations is not only good fundamental analysis of the Forex market, but it's just plain old common sense, as well.
About the Author
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Jason Fielder - Founder, Forex Impact
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