The fundamental analysis highlights various factors that influence the exchange rate. At the same time, the degree of their significance for the justification of market fluctuations is different. So at the end of the last century, investors carefully monitored indicators of money supply and budget deficit, in the first half of this century they gave way to the state of trade balance and dynamics of interest rates, now the attention of the world community is focused on foreign debt and volumes of government lending.
However, it should be borne in mind that all fundamental factors are closely related to each other and to predict the dynamics of exchange rates in the medium or long term it is necessary to understand this relationship. The interest rate is here to help. Today we will find the answers to the following questions: how does the interest rate influence the quotes on the currency market? Is it possible to make money from the interest rate? And how can you predict the exchange rate in this regard?
How to trade Fed rates - What is the Fed funds rate?
This is the interest rate at which US banks give their excess resources for short periods (usually overnight) to other banks. The borrower bank and the lender bank agree on an interest rate for the loan.
Moreover, it is also a benchmark for all the interest rates, as well as the principal instrument employed by the central bank to impact the US economy.
One of the most important rates determined by the interest rate is the prime rate - the current rates are priced by banks to their best customers. It influences multiple consumer interest rates, covering rates on deposits, bank loans, credit cards, and adjustable-rate mortgages.
How to trade Fed rates - How is the rate determined and when is it released?
The Fed functions as a central bank, but the hallmark of the system is that it is not owned by the state, but by outside individuals, as the Fed is a joint-stock company, whose shares have a special status. The state adjusts the Fed's operations by appointing its managers, which is implemented by the president after the Senate has approved the appointment. The Federal Reserve is accountable for the stability of the financial system, implements monetary policy, decides on interest rate changes, issues US dollars, is a body supervising banking institution, renders financial assistance to depository institutions and the U.S. government, and controls risks in financial markets.
The Fed regulates the activities of the twelve Federal Reserve Banks (FRB) which are situated in the twelve most developed states of the USA. Thus, decentralization and global coverage of the entire U.S. economy is achieved. The Fed exercises control over member banks, which are over five thousand. The member banks themselves own the shares of the FRB. The member banks nominate six out of nine representatives to the board of their territorial FRB.
The Federal Reserve is supervised and the presidents are appointed by the Federal Reserve Board of Governors, which consists of seven permanent members. The Board is the main management unit of the Fed. Appointment to the Board takes place in a complex structure where the initiative for nomination comes from the president and goes through Senate approval. Council members are elected for a term of 14 years, which is many times as long as the president's term of office. The Council is headed by its chairman, who is nominated by the U.S. president for a four-year term.
The Open Market Operations Committee (a committee within the Federal Reserve System) decides on the adjustment of the economic rate and changes the current interest rate, thus influencing monetary policy, as well as making decisions on transactions with securities (US bonds). This committee consists of twelve members, including seven members of the Federal Reserve Board of Governors, the presidents of the Federal Reserve Bank of New York, and four of the twelve presidents of the Federal Reserve elected by vote. The committee meets eight times a year. If conditions demand discussion or consideration of action within these regular meetings, members may be called on to participate in a special meeting or a telephone conference. At each regularly scheduled meeting, the Committee votes on the policy to be carried out during the period between meetings.
Also, twice a year the head of the US Federal Reserve speaks at hearings in Congress and Senate committees.
Usually, these speeches assess the state of the U.S. economy, its forecasts for the coming months, as well as indicate the dangers to the economy and measures to prevent them adopting the means operated by the Federal Reserve. Besides, the markets are given a signal as to what policies the Fed will follow in achieving its goals. This allows market participants to adapt in advance and plan how to trade fed funds futures.
How to trade Fed rates - What causes changes in the rate?
The Fed attempts to accomplish its objects by organizing monetary policies that can raise or lower the money supply. It employs interest rates as a lever to boost or lag the economy.
In case the economy is lagging, the Fed has an opportunity to drop interest rates to make it more competitive for businesses to borrow and invest money. More moderate rates additionally urge customers to acquire and consume money. When the fed funds rate decreases, mortgage, and other long-term loan rates drop accordingly.
The Fed essentially regulates the money supply by means of purchasing or trading securities throughout a means known as open market operations. Meanwhile, the Fed buys bonds from a bank, it expands the volume of money in the bank’s reserve account at the Fed. Having a higher supply of funds, there is an urge to cut the rate of interest it charges borrowers.
We cannot but mention the demand and supply factor. At the micro-level, if a bank encounters greater demand for its loans related to its supply of deposits, then its interest rates should enhance. To loan extra money, the bank must acquire additional expenses—either from borrowing money from another bank, increasing capital, or raising the rate it should compensate clients to bring additional deposits.
Finally, the bank passes these costs on to borrowers as higher interest rates.
Moreover, interest rates also can change due to inflation. High inflation, or foreseen inflation, will bring with it higher interest rates
How to trade Fed rates - What can we learn from Fed interest rate history?
As we can see from history, the Fed has always been trying to hold the interest rate in a range from 2.0% to 5.0% to keep the economy in good shape. But some exceptions also have a say. Let`s now briefly go through the history of the fed funds rate for us to get a general understanding of where we are and where we are going.
First off, we should note that now the target rate range for the interest rate is in a range from 0% to 0.25%—after the Fed cut it twice in March 2020, because of the disastrous economic consequences of COVID-19.
Of course, there were moments when the rate was much higher than the perfect 2%-5% in an attempt to hold the growing inflation. But mostly, it was held under 2% to make the economy prosper.
If we go through the results of the Federal Reserve`s reactions to the economic situation and the following interest rate changes we Examining the Fed's changes we will get the understanding of how inflation and recession were tackled by the Fed.
The lowest rate recorded is zero. The Fed cut it twice to a range of 0.0% to 0.25%. The first time it was in 2008, and then in March 2020. After the first cut, rates were not raised until December 2015.
It should be mentioned that Before the financial crisis in 2008, the minimum rate was a range of 0.75% to 1.0% in 2003. It was done to resist the recession of 2001. By then, everything was showing the signs of the deflation.
As for the highest fed funds rate, it was at the level of 20.0% in 1979 and 1980. The inflation soared after Nixon released the dollar from the gold standard in 1973. Inflation nearly tripled from 4.6% to 12.3% in 1974. The Fed increased interest rates from 5.75% to a high of 11.0%. The Fed continued boosting the fed funds rate to a peak of 13.0% in 1974. It reduced the rate to 7.5% in 1975. That only made inflation worse. Fed leaders learned that managing inflation expectations was a crucial circumstance in controlling inflation itself.
In 1979, the Fed chair raised rates and held them there to ultimately end inflation. That created the 1980 recession but completely ended double-digit inflation. It hasn't been a threat since.
Till 1979, the FOMC didn't state its target interest rate after meetings. The Fed tightened the rate throughout its open market operations and banks were reluctant to guess what the rates would be. The Fed attempted to combat inflation without managing the expectations of inflation.
In 1979, the Fed started planning the money supply to combat inflation. As a result, the fed funds rate varied dramatically between 1979 and 1982. In 1982, the Fed determined to plan the fed funds rate precisely.
Later in 1994, the FOMC formally declared its policy changes for the first time. After that all its statements shed light upon what interest rate is expected to be. It handles the outlooks of inflation and reduces disturbances provoked by suddenness from the Fed.
How to trade Fed rates - What impact does the rate decision have on markets?
Concerning the Federal Reserve rate, the rule applicable to all rates is preserved, as it increases, the price of shares and bonds becomes cheaper and inflation slows down. However, because the Fed's rate is super strong on a global scale, there has recently been a tendency to recoup an expected increase or decrease in the rate in advance.
The speeches of representatives and heads of the Federal Reserve began to be of special significance in this case, with economic forecasts and the expected steps to change the rate. Therefore, it should be taken into account that sometimes despite the Federal Reserve's rate increase, stock markets grow and the dollar rate becomes cheaper. For example, it was expected that the rate would increase by 0.5%, but in fact, it was only 0.25%. In the same way the interest rate may decrease.
Let's take a closer look at the impact of the Fed's rate on various markets.
Even though the interest rate has a direct impact on currency markets, in practice it is not always obvious. Ideally, if the rate increases, it becomes more profitable to keep dollars and dollar assets. But the currency market today is influenced by many other important factors as well - the balance of payments of the states, speculative operations of major players, the monetary policy of other states.
The reaction of the stock market to changes in the Federal Reserve's rate is usually the opposite. A decrease in the Fed interest rate is a positive factor for trading platforms of many states.
As the rate increases, the opposite effect occurs and stock markets decrease.
A higher interest rate implies lower bond prices.
Thus, the bond price and the interest rate are inversely related: the higher the interest income, the less you have to pay now to get a certain amount of income in the future, i.e. as the interest rate of the bond chain rises, the demand for the bonds falls, accordingly, as economic agents prefer to buy bonds rather than leave money in their hands. This means that the demand for money at a high-interest rate will be small.
Let us consider in detail the impact of changes in interest rates on the Forex market:
High-interest rates will increase the investment attractiveness of the currency;
There will be an increase in demand for money;
As a result, the currency rate in the Forex market will go up.
At the same time, there are scenarios when rising interest rates do not lead to an increase in the rate:
A high inflation rate may lead to significant sales in the bond market with an excess of cheap currency. This will further exacerbate inflation;
The central bank will decide to increase the interest rate to contain inflation;
This will strengthen the monetary unit of the country and attract foreign investors;
However, expensive loans have severely worsened the country's economy, as none of the producers wanted to bear the cost of servicing them;
Deterioration of the economy has reduced investment, while at the same time there is a shortage of goods in the market and producers have started to raise prices increasing inflation;
Failure to meet its targets forced the Central Bank to lower the base rate.
To correctly use the information about the interest rate, the trader needs to know what market and how to evaluate it, know the importance of key rates of different countries, and the economic situation in the country of investment.
How to trade Fed rate decisions
Changes in interest rates have a strong impact on the market, both Forex and stock, and learning how to trade fed funds futures provides good opportunities for trading. Usually, an increase in interest rates leads to an increase in the national currency, a decrease contributes to a fall in the rate. In any case, there is a high probability of a strong market movement that can be used for trading.
Forex traders can opt to trade the result of the interest rate decision, longing or shorting the currency right at the moment it`s released.
Advanced traders, on the other hand, may attempt to forecast changes in central banker’s tones, which can shift market expectations. Traders will do this by monitoring key economic variables like inflation, and trade before the central banker’s speeches.
Another way is to wait for a pullback after the interest rate result. If the central bank unexpectedly hiked rates, the price should go up, a trader could wait for the asset to depreciate before placing a buy order - expecting that the price will continue to grow.
How to trade Fed rate decisions via the US dollar index
The US Dollar Index is an indicator of the strength of the American currency, the movement of which is monitored by many market observers and analysts. It includes a basket of foreign currencies; whose value is comparable to the dollar. It is quite simple - the dollar index shows how the dollar feels about other world currencies, namely the euro, yen, pound, Canadian dollar, Swedish krona, and Swiss franc. DXY is a handy index, which is used as a simple method to determine the strength and weakness of the U.S. dollar.
The dollar index can be used to analyze currency pairs in the forex market, as well as stock market investors use stock indices as an underlying contract to determine the general trend direction in the market. If you are trading currency pairs that have USD currency in their quote, the dollar index will give an idea of the relative strength of the dollar in respect of currency pairs like EUR/USD, GBP/USD, USD/CHF, etc., and in case of uncertainty, the forecast will give a clearer picture of the market. We can safely say that USDX correlates with the above currency pairs and this indicator a trader can use as an additional indicator in market analysis.
Many people are constantly monitoring the DXY not only for coincidence but also for the divergence with the same EUR/USD, as this divergence can be considered a divergence.
If the DXY shows increased volatility, it will be reflected in other currencies of the index, a breaking-through of the support/resistance level on one chart corresponds to a breakthrough on the other.
The DXY is influenced by general factors that affect the currencies, such as fiscal and monetary factors, interest rates, inflation, and foreign trade. That is why an analysis of the Dollar Index can provide you with an excellent basis for developing your long-term trading strategy.
How to trade Fed rate decisions using price action signals
The Price Action strategy allows the trader, who uses it, to work with the price, i.e. to be closer to the source, while the trader, who works only with indicators, is as if a step further from what he earns.
Work on Price Action is structured as follows:
First off, wait for the price chart to approach the support or resistance level (according to the author's observations, it is better to use resistance levels, as bullish trends are usually a little slower and longer than bearish ones - the price rises longer than it collapses).
We wait for Japanese candlesticks formed near the level line to form this or that pattern model, usually, the more complex the pattern is - the more correct the signal.
We wait for the pattern to be confirmed so that it will be fully formed, and the chart will move in the assumed direction.
We open the order in the right direction.
By the way, you can use a stochastic oscillator or MACD, with delayed settings. If it is stochastic, then the setting of periods 21-9 and slowdown 9 gives a good result and often confirms the price action with its signals.
The most commonly used patterns are:
Engulfing is a strong reversal pattern, a sufficient reason to open an order. engulfing is a pattern reversed from the internal bar. A reversal formation, which can be quite successful if it appears near the support-resistance level.
TBH - two or more Japanese candlesticks with an equal maximum means that the resistance level, which has formed such a pattern, is under very serious pressure, and the chart can either break it, which will allow it to go up to the next level, or move back to consolidate. TBH is a medium-strength reversal pattern - sometimes it does not have enough strength to reverse the price. It appears when the bullish trend changes to bearish.
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