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    The Role Of Interest Rates

    Using the interest rates independently from the real economic environment translates into a very expensive strategy. Because foreign exchange, by definition, consists of simultaneous transactions in two currencies, then it follows that the market must focus on two respective interest rates of each country as well.

    This is referred to as the interest rate differential and is a basic factor in the markets. Forex Traders react when the interest rate differential changes, not simply when the interest rates themselves change. For example, if all the G-5 countries decided to simultaneously lower their interest rates by 0.5 percent, the move would be neutral for foreign exchange, because the interest rate differentials would also be neutral. Of course, most of the time the discount rates are cut unilaterally, a move that generates changes in both the interest differential and the exchange rate. Forex traders approach the interest rates like any other factor, trading on expectations and facts. For example, if rumour says that a discount rate will be cut, the respective currency will be sold before the fact. Once the cut occurs, it is quite possible that the currency will be bought back, or the other way around. An unexpected change in interest rates is likely to trigger a sharp currency move. Other factors affecting the trading decision are the time lag between the rumor and the fact, the reasons behind the interest rate change, and the perceived importance of the change. The market generally prices in a discount rate change that was delayed. Since it is a fait accompli, it is neutral to the market. If the discount rate was changed for political rather than economic reasons, a common practice in the European Monetary System, the markets are likely to go against the central banks, sticking to the real fundamentals rather than the political ones. This happened in both September 1992 and July of 1993, when the European central banks lost unprecedented amounts of money trying to prop up their currencies, despite having high interest rates. The market perceived those interest rates as artificially high and, therefore, aggressively sold the respective currencies. Forex traders deal on the perceived importance of a change in the interest rate differential