Five Key Factors that Move the Forex Markets -- and How to Profit from Them

Key Factor 1. Interest Rates.

We use two methods to profit from the difference in countries' interest rates:

• interest income
• capital appreciation

Generating interest income.

Every currency in the world comes attached with an interest rate that is set by its country’s central bank. All things being equal, you should always buy currencies from countries with high-interest rates and finance these purchases with currency from countries with low-interest rates.

For example, as of the fall of 2006, interest rates in the United States stood at 5.25%, while rates in Japan were set at .25%. You could have taken advantage of this rate difference by borrowing a large sum of Japanese yen, exchanging it for US dollars, and using the US dollars to purchase bonds or CDs at the US 5.25% rate. In other words, you could have borrowed money at .25%, lent it out at 5.25%, and made a 5% return. Or you could save yourself all the hassle of becoming a money lender by simply trading the currency pair to affect the same transaction.

Generating income from capital appreciation.

As a country's interest rate rises, the value of the country's currency also tends to rise -- this phenomenon gives you a chance to profit from your currency's increased value, or capital appreciation.

In the case of the USD/JPY spread in 2005 and 2006, as the US interest rates stayed higher than Japan's, the dollar continued to increase in value. Investors who traded yen for dollars gained from interest income (as explained in the section above) as well as the US dollar's capital appreciation.

Figure 1-1. Between January 2005 and November 2006, as the spread between US and Japanese interest rates widened, so did the spread between the currency values. A wide spread in currency values provides investors with a ripe opportunity to earn income through both interest income and capital appreciation.

Interest Rates Spark a 700 Point Rally

Another great example of the power of interest rates in the currency market occurred in August of 2006. At that time, the Bank of England surprised the market by raising its short-term rates from 4.5% to 4.75%. Interest rates for Japan were still at a low .25%.

The rise in England's interest rates widened the interest rate differential on the popular GBP/JPY cross from 425 basis points to 450 basis points. Investment money flowed into Great Britain as traders bought up pounds to take advantage of the new spread. As the demand for the GBP increased, the value of the GBP increased, and the spread between the currencies increased. This domino effect lead to a 700-point rally in the GBP/JPY over the next three weeks.

Figure 1-2. When the Bank of England raised short-term interest rates in August 2006, it lead to a 700-point rally in the GBP/JPY over the next three weeks.

80 Points in Less than 24 Hours

More recently, we have used interest rate differentials to successfully predict several profitable trades for Forex Advisor members.

The concept of interest rates can be used to trade currencies using both long- and short-term perspectives. On a long-term basis, we look for major themes. On a short-term basis, we look for surprises in the news that shift the market’s interest rate expectations. We were able to make two winning trades based on short-term interest rate flows in the Australian dollar/Japanese yen (AUD/JPY) currency pair on January 24, 2007.

The trigger for our trade was the surprise drop in Australian consumer prices during the fourth quarter. The market was looking for hot inflation numbers but instead they received cold ones. Low inflation numbers meant the central bank of Australia was not likely to raise interest rates as expected. This news sent the Australian dollar tumbling hard against the Japanese yen, as traders speculated that the interest rate differential between the two currencies would no longer grow.

The first trade we made on January 24 banked us 45 points. We took profit before the currency pair retraced and then sold it again when it showed further signs of weakness. The second January 24 trade produced an additional 35 points for a total of 80 points.

Australian dollar vs. Japanese yen, January 24, 2007. By predicting the affect of unexpectedly low inflation on the Australian dollar, we made two winning trades on January 24. Combined, these trades netted us 80 points in one day.

Five Key Factors that Move the Forex Markets..
..and How to Profit from Them!

1.Interest Rates 2.Economic Growth 3.Geo-Politics
4.Trade and Capital Flows 5.Mergers and Acquisitions