Interest Rate Differentials: What Are They For?

As it was widely expected, the Federal Reserve rose its benchmark interest rate by 25 basis points earlier this week, leaving it in a range between 1.50 percent and 1.75 percent.

The US regulator also reinforced its commitment to move forward with the monetary normalization plan, which includes another two interest rate moves this year.

However, there were expectations that the US central bank would announce a potential fourth interest rate move for 2018. Fed Chair Jerome Powell reassured the economy is performing well, and even upgraded the gross domestic product estimation for next year.

But the United States monetary system is not the only one out there. In fact, the European Union and other nations have strong influence in currency and stock markets too.

Have you heard of “interest rate differentials” before? Don’t worry. It’s never late to embrace a new definition. So let’s begin with a simple definition:

“The interest rate differential (IRD) measures the gap in interest rates between two similar interest-bearing assets. Traders in the foreign exchange market use interest rate differentials (IRD) when pricing forward exchange rates.”

Source: Investopedia

So… What are IRD used for in the Forex market? Basically, to trade. Yeap, pretty much that. Buy or sell, the only two options available so far. The spread between rates can help a trader identify potential changes in currency pairs.

An increasing differential reinforces the higher-yielding currency, while a narrowing one benefits the lower-yielding currency. So, no rocket science to get a sense of how to use IRDs.

As the European Central Bank is moving slowly to monetary normalization, expectations for a strengthening of the US dollar are not that strong.

The EURUSD will find a clearer path once the ECB expresses a defined posture on monetary policy and therefore, helps to shape expectations on policy.

FortFS