Interest Rates and Carry Trading. Useful Information to Remember

You should learn forex trading using a good proven and tested forex system.Any forex trader knows that interest rates are an integral part of investment decisions and can drive the currency as well as the stock markets in either direction. FOMC rate decisions are the second largest currency market moving release behind the unemployment figures.

The impact of the interest rate changes not only have short term consequences but also have long term impact on the currency markets. One Central Bank’s decision can affect more than a single currency pair in the interconnected forex markets.

In forex trading, an interest rate differential is the difference between the base currency interest rate and the quoted currency interest rate. In the currency pair, EUR/USD, EUR is the base currency and USD is the quoted or counter currency. The interest rate differential for the EUR/USD pair will be the difference between the Euro interest rate and the USD interest rate.

The reason why it is profitable is that international investors like hedge funds, big banks and institutional investors are yield seekers. They actively keep on shifting funds from the low yield assets to high yield assets.

Interest rate differentials are considered to be the leading indicators for currency prices. London Inter Bank Offer Rate and the 10 year government bond yields are usually used as leading indicators of currency movements.

Take an example, suppose the Australian government 10-year bond yield is 5.25%. The US government 10-year bond yield is only 1.75%. The yield spread in this case would be 350 basis points in favor of the AUD.

Suppose the Australian government raises its overnight interest rate by 25 basis points. The Australian 10 year government bond yield would appreciate to 5.50%. Now, the new yield spread between AUD and USD is 375 basis points in favor of AUD. The Australian Dollar will also be expected to appreciate against US Dollar.

The general rule of thumb is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against other currencies. This information should be very important for your trading. Use the data available on Bloomberg to keep track of currencies in the currency pairs that you trade.

Carry trading is done by many investors to take benefit of the basic economic principle that money flows where the returns are high. This constant flowing in and out of capital between the different markets is what makes carry trading profitable.

Carry trading is one of the fundamental trading strategies employed by professional forex traders. Leveraged carry trading is one of the favorite strategies employed by hedge fund and investment banks. You as a forex trader can also benefit from carry trading.

What is a carry trade? In nutshell, carry trading means taking advantage of interest rate difference between two currencies in a currency pair. Investors take benefit of the interest rate differential between two currencies by going long/buying the high interest rate currency and going short/selling the low interest rate currency.

Let’s take an example: suppose New Zealand dollar offers an interest rate of 4.75% while the Japanese yen offers an interest rate of 0.25%.

An investor will want to benefit from this interest rate differential. He/she will buy New Zealand dollars (NZD) and sells Japanese Yens (JPY). He/she can earn a profit of 4.75-0.25=4.5% so long NZD/JPY exchange rate does not change. If the investor can handle leverage and uses a leverage of 20:1, this 4.5% return will be magnified into 90%.

Another thing that can go in favor of the investor is if the currency pair NZD/JPY appreciates, he/she can get capital appreciation as well as a yield. Many times, appreciation will also happen as many other investors also jump on the bandwagon when they see a good carry trading opportunity.

It depends a lot on the mood of the investors as a group. If investors as a group have low risk aversion, carry trading will be profitable. But if the investors as a group suddenly develops high risk aversion, carry trading will become unprofitable.

However, if the low interest currency appreciates to some extent for different reasons, carry trade will become unprofitable. In such a scenario, the more the low interest currency appreciates, the more unprofitable carry trading that currency pair will become.

How do you check the mood of the investors? By knowing whether the currency is overbought or oversold. For this you need to identify the current trend of the currency pair and see whether it is moving in the right direction!

MACD (moving average convergence divergence) indicator can help you in identifying the trend. Enter the trade when MACD crosses the zero line from below and exit when it crosses the zero line from above.

Discover a reliable and profitable source of income – forex investments!