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How inflation and interest rates affect your Forex strategy

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As a forex trader, it is important to keep on top of economic events that may influence the value of a currency. Two important measures to track are inflation and interest rates, which have a direct if complicated relationship with currency prices.

With inflation being a major news talking point as the world returns to a new normal following 2 years of pandemic disruptions and fears of interest rates rising, it is good to be familiar with their impact and what actions you can take.

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It is a similar story in the USA, where inflation is at its highest level in 10 years. This rate is 7.30% for October 2021, a rise of 1.10% in just one month.

picture2One of the major drivers of the current rise in inflation is due to supply chain bottlenecks following COVID-19 related lockdowns. Energy has been a major commodity affected by this bottleneck, with prices increasing 23% year on year. Another driver of inflation has been the high levels of spending by governments to keep economies afloat, while economies have largely shut down.

Why inflation matters

Central banks accept a little inflation since this is natural in a growing economy. The issue becomes when inflation rates are higher than the tolerance level of the country’s central bank.

When inflation exceeds forecasts, then central banks may consider the need to increase interest rates. While central banks want their economy to grow, they also need to ensure consumers can afford to pay for what they need without undue financial stress.

Increased interest rates put clamps on inflation growth, which makes borrowing more expensive. Higher interest rates encourage consumers and business to borrow less and save more, this has the effect of slowing down 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 USA predicted rates are 2.26% n 2021, 2.4% in 2022 and 2.5% in 2023.

With inflation presently exceeding these forecasts, investors should prepare to deal with future uncertainty.

The questions forex traders need to ask themselves with inflation

Countries with higher interest rates encourage global capital to flow into their country. If you are an investor, you will want to invest in a country that generates the greatest return, and this has the effect of strengthening the countries currency.

As a forex trader, you don’t want to wait for interest rates to go up since the market has already ‘priced’ this rise into the currency price. For this reason, it is worthwhile asking yourself the following questions regularly when making an investment strategy.

  1. Will inflation go up
  2. Will increases in inflation result in an interest rate increase
  3. Will increased interest rates result in a slowdown in the economy
  4. Are there other considerations that can affect forex prices

For point 4, it needs to be remembered that forex trading is complex and there are many other factors that can influence forex rates, such as political stability, employment levels, and government debt. Nevertheless, inflation and interest rates are 2 important factors to keep in mind.

The actions you need to take as a forex trader

 If you don’t believe inflation will increase

Just because recent inflation trends are upward, they can settle. The US central bank, for example, believes the current rise in prices is transitory due to supply chain bottlenecks, which will pass with time. For this reason, the US does not plan to increase interest rates in the immediate future.

If this is the case, then you may need to consider other factors that can influence forex rates and what trading actions you need to make.

If you believe interest rates will go up without affecting the economy

If you believe interest rates will go up but don’t think this will affect economies, then you might wish 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 believe economies will be affected by increased interest rates

Lastly, if you believe interest rates will go up and this will affect economies, then you might wish to consider a hedge of some sort. One option is to invest in gold, traditional hedge traders in a slowing economy.

If you wish to stick to forex trading using a CySEC currency broker ways to hedge include:

Hedging forex with options and forwards

Both 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 options don’t oblige you to buy or sell at the price while forwards do. Options, therefore, give more flexibility, while forwards are cheaper.

Forex correlation hedging strategy

You can hedge your position by opening one long position and one short position using two different forex pairs that have a positive correlation. This option is not limited to currencies pairs, as you can swap the second currency pair for a commodity such as gold.

While correlation is more of a neutral strategy, a smart trader would know which currency pair to favour in any hedge. At worst, it protects you from fluctuation and can help diversify your portfolio.

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