How Inflation and Interest Rates Affect Your Forex Strategy
As a forex trader, it is important to keep abreast of economic events that may influence the value of a currency. Two important metrics to watch are inflation and interest rates, which have a direct but complicated relationship with currency prices.
With inflation being a major topic of discussion as the world returns to a new normal after 2 years of pandemic disruption and fears of rising interest rates, it’s good to know their impact and what steps you can take.
It’s a similar story in the United States, where inflation is at its highest level in 10 years. This rate is 7.30% for October 2021, an increase of 1.10% in just one month.
One of the main drivers of the current rise in inflation is due to supply chain bottlenecks following lockdowns related to COVID-19. Energy has been a major commodity hit by this bottleneck, with prices rising 23% year over year. Another driver of inflation has been the high levels of government spending to keep economies afloat, as economies largely shut down.
Why inflation matters
Central banks accept a little inflation because it is natural in a growing economy. The problem arises when inflation rates are above the tolerance level of the country’s central bank.
When inflation exceeds expectations, central banks may consider the need to raise interest rates. If central banks want their economy to grow, they also need to ensure that consumers can afford to pay for what they need without experiencing undue financial stress.
Rising interest rates put the brakes on the growth of inflation, making borrowing more expensive. Higher interest rates encourage consumers and businesses to borrow less and save more, which in turn slows the economy.
The latest inflation forecasts for the euro area are 2.2% in 2021, 1.7% in 2022 and 1.5% in 2023. While in the United States, the forecast rates are 2.26% in 2021, 2.4% in 2022 and 2.5% in 2023.
With inflation currently exceeding these expectations, investors should be prepared for future uncertainty.
Questions Forex Traders Should Ask About Inflation
Countries with higher interest rates encourage global capital to enter their country. If you are an investor, you will want to invest in a country that generates the most returns, and this has the effect of strengthening the currency of the country.
As a forex trader, you don’t want to wait for interest rates to rise since the market has already “built” this rise into the price of the currency. For this reason, it is worth regularly asking yourself the following questions when developing an investment strategy.
- Will inflation increase
- Will rising inflation lead to higher interest rates
- Will rising interest rates cause the economy to slow down
- Are there any other considerations that can affect forex prices
For point 4, it should be remembered that forex trading is complex and that there are many other factors that can influence exchange rates, such as political stability, employment levels and public debt. Nevertheless, inflation and interest rates are 2 important factors to keep in mind.
Actions you should take as a forex trader
If you don’t believe inflation will increase
Just because recent inflation trends are on the rise, they may take hold. The US central bank, for example, believes the current price hike is transient due to supply chain bottlenecks, which will subside over time. For this reason, the United States does not plan to raise interest rates in the immediate future.
If this is the case, you may need to take into account other factors that can influence the exchange rates and the trading actions you need to take.
If you think interest rates will rise without affecting the economy
If you think that interest rates will go up but it won’t affect savings, you may want to consider investing in currencies that will have higher interest rates.
A country with a higher interest rate has the potential to have a stronger currency than economies with lower interest rates
If you think your savings will be affected by rising interest rates
Finally, if you think that interest rates are going to rise and it will affect savings, you might want to consider some sort of hedging. One option is to invest in gold, traditional hedge traders in a slowing economy.
If you want to stick with forex trading using a CySEC Currency Broker ways to cover yourself include:
Currency hedging with options and forwards
The two strategies are similar in that you, the trader, have the right to buy or sell currency pairs at a specified price in the future. The difference is that options don’t require you to buy or sell at price, whereas futures contracts do. So options offer more flexibility, while futures are cheaper.
Forex Correlation Hedging Strategy
You can hedge your position by opening a long position and a short position using two different currency pairs that have a positive correlation. This option is not limited to currency pairs, as you can trade the second currency pair for a commodity such as gold.
While correlation is more of a neutral strategy, a savvy trader would know which currency pair to favor in any hedge. At worst, it protects you from fluctuations and can help diversify your portfolio.