In the foreign exchange market, different currencies are affected by different things. Some are more vulnerable to geopolitical conflicts, while others tend to be safe havens in times of such uncertainty. We can definitively say that no two currencies behave very much the same.
Now, when you invest in the forex market, you don’t only choose one currency. You trade them in pairs. Therefore, you’re always dealing with two countries. And, just like currencies, two countries are affected by different things, like interest rates.
This is where interest rate differentials enter the picture.
What are interest rate differentials?
A huge number of forex traders choose to compare one currency’s interest rate to another currency’s interest rate. You can use this as your starting point if you are trying to decide which currency may strengthen and which currency may weaken.
The difference between the two currencies’ interest rates are known as their ‘interest rate differential.’ This is considered to be one key value that all traders, including you, should keep close tabs on.
The spread between one currency’s interest rates can help you spot shifts in such currencies that may not be obvious at first.
To get more feel of how important it is, we’ll clarify what happens.
When the interest rate differential increases, it helps to reinforce the higher yielding currency. On the other hand, a narrowing interest rate differential might be good for the lower yielding currency.
Situations where the interest rates of two countries moves toward opposite directions often result to extremely huge swings in the market. In other word, an interest rate hike in the currency of one country combined with the interest rate cut on the currency of one country is the perfect recipe for the really sharp market swings.
Nominal vs. Real Interest Rates
Many people think that when they talk about interest rates, they’re really talking about interest rates. However, this is not always the case.
When someone speaks about interest rates, he or she may be pertaining to either the nominal interest rate or the real interest rate. There’s a sea of difference between the two.
The nominal interest rate cannot always give the trader a clear view of the current economic situation of the country whose currency the trader is trading. When we talk about nominal interest rates, we refer to the rate of interest before adjustments are made for inflation.
In other words, the nominal rate is typically the stated or base rate that people see.
Now, what’s important to remember is that markets do not really focus on this type of interest rate. Instead, markets care more about real interest rates.
To calculate the real interest rate of a currency, you must subtract the expected inflation from the nominal interest rate. Thus, the equation will look something like this:
Real Interest Rate = Nominal Interest Rate + Expected Inflation
For instance, if you had a bond that sported a nominal yield of 6% and, unfortunately, inflation was an annual rate of 5 percent, the bond’s real yield would be 1 percent, which is quite a huge difference.