|Trading Forex Using Fundamental Analysis|
|Part 1: Exchange Rates and Fundamental Analysis|
|Part 2: Impact of Interest Rates|
|Part 3: Economic Indicators|
Reading time: 8 minutes
In Part 1, you were introduced to Purchasing Power Parity (PPP). An alternative to using PPP is Interest Rate Parity (IRP). Although a more complex concept, it’s a crucial aspect to understand to conduct Fundamental analysis.
For example, assume the US Federal Reserve (Fed) announced a change in its benchmark interest rate. Understanding the implications of this action and how this influences foreign exchange prices is vital.
The interest rate is the price of money
If you think of money as a unit, then just like every unit, it needs to have a price in order for buyers and sellers of the unit to assign a value.
However, it’s pointless saying ‘the price of a dollar is a dollar’. That’s just like saying ‘the price of an orange is an orange’. This is the reason why interest rates exist. Interest rates provide a foundation for a price-setting mechanism for the value of money. It allows the market to evaluate how much a country’s money is worth.
If interest rates in Country A are high, some citizens would be willing to forgo spending to take advantage of the high interest rate environment, investing funds in an interest-yielding investment such as a fixed deposit account or bonds. Additionally, overseas investors may also be eyeing similar investments, especially if their domestic interest rate is low. Nonetheless, foreign investors must acquire the country’s currency first before investing in any of Country A’s financial instruments.
Investors, of course, would have to hold that investment for a t amount of time to yield the required interest. Assuming t is one year, during that year, country A’s currency will either appreciate/depreciate. If it is the latter, foreign investors may end up with less money than the initial investment if the percentage of currency depreciation is more than the investment’s interest rate. Therefore, foreign investors must take into consideration not just interest rates, but expectations of what the exchange rate could be in a year before investing. This is the building block of IRP theory and in a two-country model the equation is as follows:
To illustrate, if country A is the United Kingdom and country B is the United States and you want to know what the exchange rate ought to be in 1 year, the interest rates for both the UK and US are required. The Bank of England’s Official Bank Rate is usually used as a benchmark rate for the UK, while for the US it is the Federal Funds Rate (FFR), determined by the Federal Open Market Committee (FOMC). Both are overnight rates and listed as per annum (p.a.). A quick check shows the Official Bank Rate and the FFR in Aug 2020 is 0.1% p.a. and 0.25% p.a., respectively.
Since both interest rates are close to zero, the two central banks have limited room left to cut interest rates further (both banks have been lowering rates since 2018). It is likely both rates will remain at current levels for at least the next 12 months (though there is speculation the BoE may implement negative rates) as central banks are unlikely to raise rates amidst the Covid-19 pandemic. Given the exchange rate between the two countries is 0.7702 at end-October 2020, the formula for this is as follows:
From the above, the exchange rate at end-October 2021 should be lower than 0.7702 to maintain parity. What this means is the USD is expected to depreciate in the coming year though not by much because the interest rate differential between the two countries is small. If you compare two countries with a sizeable interest rate differential, the magnitude of Forex movements of the currency pair may be much larger.
You can also predict the exchange rate for different investment horizons based on individual investment objectives; it need not be a year. Remember, however, since you’re using p.a. interest rates, you must divide by 365 to ascertain the interest rate for one day, and then multiply the daily rate with the length of your investment horizon to calculate F. However, if you’re a trader with a short investment horizon, such as a day trader (day trading), another way of using IRP is to forecast ε or the spot exchange rate. To do that, you would need to know F first. If you want to know what the 1-year forward exchange rate is for USD/GBP on 12 November 2020, various online sources show it’s approximately 0.7600, which means the spot exchange rate ought to be 0.7611. You can compare the actual exchange rate on your trading platform with this level to guide on exchange rate direction during your daily trading.
To summarise, the setting of interest rates by central banks is known as monetary policy. In fact, monetary policy is the raison d’être for central banks. It is an important macroeconomic tool and a change in rates greatly affects the exchange rate. Consequently, central bank meetings to determine interest rates are major news events on any economic calendar.
To help master fundamental analysis, marking these events on your calendar, along with additional economic data releases you will read about in Part 3, is essential.
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