How to trade forex when interest rates are falling? (2024)

Academy News How to trade forex when interest rates are falling?

Published:07.02.2024

For forex traders, interest rates are one of the most important factors. They are the basis for calculating swaps, or interest rate differentials between two currencies. These determine how much a trader will receive or pay for holding a position overnight. The swap can turn a profitable position into a losing one and vice versa.

The year 2024 is expected to be a year of declining interest rates around the world, which can bring many opportunities for forex traders. There is no need to write about the events of the last 4 years, the huge rise in inflation has caused interest rates to rise, even to all-time highs in some markets. However, inflation has been falling for over a year now, so we expect aggressive interest rate cuts just this year. A forex trader can potentially benefit from this in at least 2 ways.

First way: speculation at the central bank meeting

The dates of central bank meetings have long been known, as have the actual decisions of central bankers, often in advance. However, this could change in 2024, and there are sure to be many surprises at the upcoming meetings. The greater the surprise, the greater the market reaction can be expected.

Possible market reactions:

1. An earlier-than-expected cut in interest rates may cause the currency to depreciate. Lower interest rates make the currency less attractive to foreign investors.
2. Conversely, rejecting market expectations and holding higher interest rates may cause the currency to strengthen.

The latter scenario is very real this year, for example in the US. The Fed Governor has already denied several times that interest rates should fall in March. The current labour market data only confirm this theory. Below are the probabilities of interest rates being set at the May meeting. The market is now attributing a 25 or even 50 basis point cut in interest rates to a 64% chance. However, the market may sober up from this expectation as well, and we may not see the first cut until June, also in view of renewed concerns about the spread of inflation due to events in the Middle East.

_{Probabilities of US interest rates at the May meeting. Source: CME}

However, nothing is ever black or white in the markets; the same decisions can often have opposite consequences. Sometimes the phenomenon of "buy the rumor, sell the news" occurs in the markets. In anticipation of a decision, the market is already moving in the direction the market expects before the decision is made. This is then already priced in and, in turn, may be sold after the decision itself.

A practical example: the dream pivot to JPY?

Interesting trading opportunities arose towards the end of last year just before the Bank of Japan meeting. The Japanese Yen is near long-term highs on the pair with the USD and the still negative interest rates that the Bank of Japan continues to hold are not very positive for the Yen's strength. Inflation in Japan has picked up for the first time in a long time and has been above the central bank's 2% target for 2 years. Thus, wages are rising in Japan for the first time in a long time and the market is still waiting to see when the central bank will make a U-turn and raise interest rates for the first time. With the new leadership of the Bank of Japan, expectations have only intensified and the market was already heading towards lower levels ahead of the meeting and the yen started to strengthen.

_{The USD/JPY currency pair on the H4 chart in the MT4 platform}

The chart above shows the situation on the USD/JPY pair before the Japanese central bank meeting on October 30, 2023. At the meeting, the bank decided to maintain negative interest rates, which immediately led to a depreciation of the JPY. This situation continued to repeat itself until the end of the year - several trading sessions before the actual central bank meeting, the markets were already betting on the fact that there would be a pivot and an interest rate hike. However, this did not happen and the JPY is still holding near multi-year highs on the USD pair. However, a rate hike is likely to happen in Japan in 2024 and the timing may be very interesting for position traders.

Second way: position trading and carry trade

Position trading is a style of trading in the financial markets in which an investor holds their trading positions for an extended period of time, often several weeks to months. In position trading, investors focus on identifying long-term trends in the markets. In doing so, they seek to take advantage of these trends and maximize their potential profits.

Due to the fact that a trader holds a position for several weeks or months when position trading, he/she has to take into account not only technical but also fundamental analysis. Technical analysis deals with the movement of the price on the chart, which can be supplemented by various indicators. Fundamental analysis looks at how macroeconomic indicators such as gross domestic product, inflation, employment, etc. affect the price of a given instrument.

Position trading is suitable for trending markets, which traditionally include commodities and stock indices. However, even forex markets can trend and a change in interest rates can be the trigger for this trend. Another important factor comes into play here - if a speculator buys a currency that has a significantly higher interest rate and in turn sells a currency that has a lower rate, he or she also collects positive swaps. A carry trade is a strategy where traders take advantage of the difference in interest rates between two currencies. In times of falling interest rates, traders might choose to invest in the currency with the higher interest rate and hold the position for a short period of time to profit from the difference. However, this strategy is not without risk, and it is important to monitor macroeconomic factors that can affect the exchange rate.

_{Rising and falling trend on the USD/JPY pair. D1 chart in MT4 platform}

The aforementioned USD/JPY pair was also the go-to instrument of carry traders. Thanks to rising global tensions and interest rates in the US, the US dollar has become extremely popular. In contrast, Japan has long held negative interest rates. Position traders who bought the USD/JPY currency pair and held it for a longer period of time thus not only had a capital gain, but also a regular one from swaps.

Recommended articles