Forex Trading: Policy Breakdown

No one can control the Forex Market. With a daily trading volume of an estimated $6 trillion US dollars, no single person can determine where the markets will move, and what time the markets will move. Nonetheless, as the forex market is trading the currencies of nations and countries, it is not surprising that the policies of nations and countries can affect the markets to a certain extent. That being said, not many of us understand what these policies mean or what they signify. In this blog post, we will be identifying several basic concepts when it comes to the policies nations and countries announces, and that they mean for us.

When a country raises their interest rates, that country’s currency is strengthened. This is so because a higher interest rate will make it more attractive to investors, as their returns from their investments will be higher. As such, more people may purchase this currency, pushing its value up. Relatively speaking, it would mean that another country’s interest rates are considered lower than the former country’s interest rates. Based on the sentiments of the investors, it will not be surprising if the currency pair between those two countries were affected by the increase in interest rate.

Another term that can be used to describe a hike in interest rates will be that a hawkish monetary policy is favoured. This term describes a central bank’s preference for higher interest rates and tighter monetary control. The actions that Central Banks can take to implement higher interest rates will be a concept known as Quantitative Tightening. Quantitative Tightening refers to the removal of money from the market by selling bonds, and is often used during hawkish periods to fight inflation. The understanding of these terms can assist us in decision making in the future. For example, traders trading on fundamentals might steer away from entering sell positions, as the currency is going up and they will make a loss as the currency continues to go up further.

Conversely, when a country lowers their interest rates, that country’s currency is weakened. This is so because a lower interest rate will make it less attractive to investors, as their returns from their investments will be lower. People will start selling that currency, pushing its value down. Another country’s interest rates may then be more enticing, relatively speaking. Some reasons why a country will willingly reduce their interest rates will be to help local industries recover and borrow money at a lower cost, and to support exports, in which it is more attractive for foreign buyers to purchase that country’s goods. Another term that people use when it comes to the lowering of rates is the cutting of interest rates.

Another term commonly heard when it comes to the lowering of the interest rates is that a dovish monetary policy is favoured. This term describes a central bank’s tendency to lower interest rates and loosen monetary policy to stimulate economic growth. Central banks can achieve this via a concept known as Quantitative Easing, in which it refers to the injection of money into the market by buying bonds. This is often used during dovish periods to fight deflation. Traders that understand these terms from the announcements / news from these countries would know to steer away from entering buy positions, due to the fact that the currency is currently on a downtrend, and that they will make a loss if the currency keeps going down.

To conclude, we have seen the consequences of an increase and a decrease of the interest rates of a country. There are terms out there that we need to be familiarized with so that we do not make the wrong decision based on an assumption. Keep in mind that an increase in interest rate is the same as a hawkish monetary policy, and that Central Banks can use something known as Quantitative Tightening to increase interest rates. On the other side of the coin, a decrease in interest rates is the same as a dovish monetary policy, and that Central Banks can use something known  as Quantitative Easy to decrease the interest rates.