Interest rates are a very important part of any investment decision. Interest rate change by FOMC ( Federal Open Market Committee) is one of the most market moving announcement. This can drive the market in either direction with both short term as well as long term implications. FED’s decision to change the interest rate can affect many currency pairs.

Currency markets are also highly susceptible to interest rate changes. An interest rate differential in forex trading means the difference between the interest rate on the base currency (first currency in the pair) minus the counter currency (the second currency in the pair). Everyday at 5:00 PM EST, funds are either paid by trader to their brokers or received by traders from their brokers depending on whether the interest differential is negative or positive on the currency pairs they are trading. So knowing these interest rate differentials is highly important for a currency trader.

Majority of investors are primarily yield seekers. Large banks, hedge funds, corporations, pension funds and institutional investors are always shifting their funds from low yielding assets to high yielding assets.

Future interest rates are always of prime interest to investors and traders. This makes these interest rate differentials a leading indicator of future currency prices. Let’s make it clear with an example, suppose the Swiss 10 year government bond yield is 5% whereas the current US 10 year government bond yield is 2%. Then the yield spread would be 3% (300 basis points) in favor of Switzerland. Now, if the Swiss government decided to further raise the interest rate by 50 basis points, the new bond yield spread would also appreciate to 350 basis points. This is an indication that Swiss Franc (CHF) is going to appreciate relative to USD in future.

So how do you calculate the interest rate differentials for currency pairs? The best method is to use yields on the 10 year government bonds. THe data is easily available on Bloomberg. For example, in case of GBPUSD pair subtract the yield on 10 year US Treasury Note from the British 10 year gilt. However, in case of EURUSD use German 10 year bond instead of gilt. Keeping track of the trend in interest rate differentials overtime can give you a leading indication of appreciation or depreciation of a currency relative to the other in the currency pair.

Understanding this correlation between the interest rate differentials and currency pairs can be highly profitable. Always keep a graph of these interest rate differentials to help you understand where the currency pair is expected to head in the near future!