Last week, we talked about what swap rates were and how they relate to forex. Now, let’s see if we can incorporate that knowledge into some form that can be useful for trading. It might not be specifically a signal to start a trade. But an understanding of the background situation can help interpret signals from our existing trading strategy with more clarity.
The swap rate is effectively a difference between the interest rates of two currencies. It’s a “swap” rate, because in a forex trade, you are exchanging or “swapping” one currency for another currency. What the swap rate tells us, effectively, is which currency has a higher rate of return. A higher rate of return typically indicates increased risk.
Putting it into a trade
For a forex trader, who isn’t going to be holding the debt for a considerable period, the risk of default in a particular country is insignificant. What we’re interested in is the signal that the spread in interest rates sends to the large institutional investors who move large amounts of cash between currencies, and effectively drive the market.
To facilitate this, we probably want to take apart the two components of the swap and consider the interest rate for each currency. If we use the EURUSD as an example, let’s say the yield is 5.5% on the dollar and 5.0% on the Euro. The market will find an equilibrium to compensate for that difference in interest rates, and that will set the price of the EURUSD.
Driving the market
But, if there is a bunch of debt sold in dollars, for example, the issuer of that debt might have to offer a higher interest rate to attract buyers. That means the yield on the dollar rises, and the interest rate spread would widen. This makes it more attractive to have dollars, since you can loan them out at a higher interest rate. The dollar would become stronger, and the EURUSD would go down. The value of the swap rate would increase.
What could also happen is that at the same time, a bunch of Euro debt is also issued, which requires increasing the interest rate in a similar amount to attract buyers. That means the yield on dollars increased, but so did the yield on Euros. The value of the swap rate would stay the same, and so would the exchange rate.
Finding a signal
Therefore, swap rates reflect the relative pressure on a particular currency pair. If you see yields rising in one currency, then that currency could gain in value if the yields don’t also rise in the other currencies. And vice versa.
The market fluctuates every given second based on a wide range of factors going into millions of individual decisions made by traders. So, tracking the interest rate won’t give a specific signal. But it can show whether there is upwards or downward pressure on a particular currency, relative to other currencies.
If you are trading in an environment in which yield spreads are showing upward pressure on the dollar, then prioritizing signals that provide dollar buying opportunities might mean more of your trades will work out.
