How To Profit From Forex Interest Rate Rise?

Forex interest rate rise is one of the very driving force behind currency supply and demand.

Think of a currency as a stock of a country. When you own a stock of say, Google Inc. you also own a portion of ownership. Likewise, when you own currency (invest in currency) you also own a portion of country.

Let's make an analogy between investing in stocks versus investing in currency.

Investors who plan on to build a solid stock portfolio start by discerning the market that has some positive prospects.

Next the investor will narrow down decision to few handful investment portfolios that should return decent yields in the months to come.

In the case of currency, investors look to invest in countries with potential economic growth in the future and higher forex interest rate.

There are various economic barometers that can be used to gauge the economic health of a specific country and hence the higher forex interest rate. The most significant indicators used to gauze the health of the U.S. economy, therefore U.S. dollar are listed below.

Non-Farm Payroll (NFP)
Federal Open Market Committee Rate Decisions (FOMC)
Trade Balance
Inflation (Consumer Price Index)
Retail Sales
Gross Domestic Product (GDP)
Current Account
Durable Goods
Foreign Purchases of U.S. Treasures (TIC Data)

So before investing in currency, pick the country that has promising economic growth potential and higher forex interest rate in the coming days ahead.

For instance, the U.S. economy was hit hard between 2007-2009 due to sub-prime mortgage meltdown which resulted in global financial collapse.

So the U.S. dollar in that period performed poorly as compared to Euro (EUR) and other currencies like Canadian dollar or Loonie (CAD), Australian dollar or Aussie (AUD) and New Zealand Dollar (NZD).

Be that as it may, the U.S. economy is very resilient and when it does leap back on track the U.S. dollar is going to outperform the rest other currencies.

So the better question might to ask if now is the right time to invest in the U.S. dollar despite low currency interest rates.

So What Is The Fundamental Saying?

Unlike stock trading, currencies are traded for more than a mere purposes of buy and hold. Currency traders buy currencies at the present price and sell for future delivery.

In other words, multi-nation corporations who trade currencies trade today for settlement a week to many months in the future. This way they can hedge against the inflation.

Just like banks offer certain interest rate on deposits made with them countries also offer different currency interest rates for buying their currencies.

This is similar to depositing your money in a bank but in this case, you will be depositing your money in a certain country.

For example: A multi-nation corporations like Google Inc. runs it's business around the globe. Google employees in Europe are paid in Euros.

Say Google Inc. needs to pay Euro 1000,000 for the month of May 2010 to cover the employee salary.

First thing Google will need is to exchange U.S. dollar to Euro.

The EUR/USD price is trading at 1.33402/1.33417 as of April 7, 2010. This exchange rate fluctuates daily.

Also, at this time Euro currency interest rate is at 1% whereas U.S. dollar currency interest rate is at 0.25%.

So if Google Inc were to purchase Euro 1000,000 right now then it will earn interest at 1%.

Unless the Euro slides drastically against the U.S. dollar, Google Inc. will be able to deliver it's employee's salary at the end of the April for better delivery price.

Moreover, if Euro gains against the U.S. dollar Google Inc. might as well benefit from surplus cash as a result of this transaction.

A nation's currency interest rates influences traders, investors and multi-national corporations to buy the currency with higher interest rate either for long term investment or for hedging purpose.

As a result, demand for high yield currency will drive exchange rates higher compared to the low yielding currencies.

So the currency interest rate is the core underlying market driving force to reckon.

How About The Investor Risk Aversion Factor?

Depending upon the political situations and economic announcements investor risk aversion factor varies from time to time, which significantly influence forex rates.

For example: As of April 7, 2010 Greece is undergoing serious budget crisis. Euro zone and ultimately Euro is heavily influenced due to Greece's economic health concerns.

Even though countries like Germany and France, which make up the majority player in Euro zone, do not like to take Greece's problem in their shoulder, but still Greece's headache is Euro zone's headache.

This is ultimately reflected in the forex market.

Euro has continued to made the lowest lows against the U.S. dollar in the past days. As the U.S. economic health improves, if Euro zone, does not find solution to Greece's budget crisis then it is likely to bet that the U.S. dollar will strengthen over the coming months despite lower forex interest rate.

Long term, everything boils down to capital flows and trade flows - flow of investment dollar moving in and out of a country either in the form of demand for equities and bonds or as the result of exports and imports. This is also the precursor to the future forex interest rate rise.

As for the U.S. dollar, many other countries who have pegged their currency to dollar. So when those countries transact in large volume, they will be essentially moving dollar in and out of their country, and across the globe.

This ultimately results to more demand for the U.S. dollar from across the globe.

So even if the U.S. economy is kind of sluggish just like in 2009-2010, these continued demand will cause dollar to appreciate over the long term.

So the key in investing currency is not only to pick currency with high currency interest rates but also with economy that is thriving and has potential to grow in the coming months to years.

So how would you employ ideas of forex interest rate in your trading? Share your story, tip or review about it.