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#1 13-09-2021 08:55:38

johnedward
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From: Paris - France
Registered: 21-12-2009
Posts: 3132
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What do the first interest rate hikes mean for currency traders?

What do the first interest rate hikes mean for currency traders?


The Reserve Bank of New Zealand is the first central bank in the developed world to make its first rate hike. What conclusion can traders draw from the market's expectations of the first rate hikes?

In the currency market, exchange rates reflect the value of one currency against another. Traders wishing to speculate on the future direction of a currency pair use various tools at their disposal - technical or fundamental.

Central banks and their actions are the main drivers of volatility in the currency market. Trading algorithms and new technologies have allowed brokers to execute orders in milliseconds. As a result, the language of central banks has changed, in an effort to be transparent and clear, to avoid unnecessary volatility.

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Of all the central banks' decisions, those concerning interest rates are the most important to traders. Simply put, the higher the interest rate, the more attractive the currency.

In the developed world, inflation has not been a problem in recent decades. The recent pandemic has changed that, but real rates (i.e., interest rate minus inflation rate) should turn positive again as central banks begin to raise rates and inflation slows.

Interpreting the market's interest rate expectations

If we use the expected changes in interest rates in the developed world and try to predict future changes in exchange rates, we get some interesting results.

For example, the Reserve Bank of New Zealand and the Bank of England are the first to have to raise their rates by 25 and 15 basis points respectively. That's an increase of 0.25% and 0.15% respectively. This may not seem like much, but when compared to, say, the -0.5% interest rate of the ECB's deposit facility rate, the gap widens.

Based on the above chart, one may prefer a short position on the EUR/NZD exchange rate, a short position on EUR/GBP, or a long position on GBP/JPY. However, trading the currency market is not that simple. There are multiple factors to consider, and the interest rate is only one piece of the puzzle.

However, interest rates offer an educated guess as to what prices are. Any deviation, such as the Bank of England delaying the hike, should create more volatility than the actual rate hike, which occurred as expected.

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