How Prime Rate Works

Commercial banks and other financial institutions, such as credit unions, offer various loan products, including short- and medium-term loans. These loans are usually targeted at the most creditworthy customers for better returns and are generally given at a constant rate for mutually beneficial reasons.

These rates are based on a foundation rate or index, the prime rate, which is the percentage they charge for loans, based on the overnight rate of the Federal Reserve’s federal funds. The Prime Rate is calculated using the following: U.S. Prime Rate = The Fed Funds Target Rate + 3.

Changes in the prime rate impact various dynamics, which influence investors’ market bias in forex trading by raising or lowering the potential returns they get on USD-denominated investments. Interest rate differentials (IRD) contrast and represent the interest between two interest-bearing assets (currencies, in this case), providing traders with insights into currency valuation and determining the attractiveness of one currency over the other.

The U.S. Federal Open Market Committee (FOMC) voted on September 18, 2024 to lower the federal funds rate to between 4.75% and 5.00%, resulting in the prime rate hitting 8.0%. The change marked a 50 basis point drop from the previous rate and reflects adjustments toward reaching inflation targets.

How Prime Rate Changes Impact Forex Trading

The U.S. prime rate impacts markets through interest rates on loans, impacting how investors trade and the capital flows.

Influence of Interest Rates on Currencies

Interest rates are fundamental for a currency’s value in the forex market. When the Fed raises interest rates, financial institutions typically raise interest rates on loans, resulting in higher yields on USD-denominated investments. This attracts more investors looking for assets with higher yields and results in a USD appreciation in the market. If the Fed decreases rates, the USD depreciates as investors look for more attractive investments.

Influence on Capital Flows

USD-denominated assets become attractive when rates are increased, leading investors to purchase more US assets and sell other currencies to buy and hold the USD for more returns. This capital flow cuts across markets, especially in the stock, currency, and commodities markets. Increased demand for the USD strengthens its exchange rate against other currencies and impacts other markets with assets priced in USD.

How Markets React to Rate Changes

Interest rate announcements usually cause immediate market changes as traders quickly adjust their positions based on the perceived impact of rates. The forex market responds the fastest, especially during the London/New York overlap, which usually has the highest volume of USD trading.

Investors always watch the Feds’ inclination and other economic indicators, such as GDP and employment figures, to predict rate decisions before buying or selling assets.

A surprise cut or increase in the prime rate can swiftly change the USD's value, triggering massive sells or buys in the currency market before prices stabilize. The market impact might be slower when investors anticipate the rate cuts.

EUR/USD Price Dynamics

The Eurozone and the U.S. are the biggest economies globally, supporting the EUR/USD, the most traded forex pair globally. The EUR/USD has an inverse relationship, where the appreciation of one typically results in a depreciation of the other. When U.S. interest rates increase and the USD appreciates, the EUR tends to weaken against the USD as investors move capital from EUR-denominated investments to USD assets.

Historical data shows that the U.S. monetary policy impacts the EUR/USD pair differently. The EUR rallied to a 13-month high against the USD following four consecutive weeks of gains as investors prepared for the Fed’s recent rate cut announcements last week. The move, the first in over a year, underlines the USD’s resilience amidst inflation and political events that forced central banks worldwide to hike rates.

Trading Strategies for Prime Rate Changes

Economic calendars are crucial to trading rate changes, providing traders with important economic news that impacts markets. Traders closely monitor the Fed’s stance and analyze the GDP, inflation rate, employment figures, and other data to predict rate decisions. Traders may wait for markets to settle after the Fed announces rates or trade short-term trends triggered by rate changes. The commonly used strategies are scalping to take small profits and day trading to ride trends before they slow down. Changes in the U.S. prime rate have widespread implications for the forex market, especially for USD pairs, such as the EUR/USD, and assets in other markets priced in the USD. Traders must understand the dynamics and align their strategies when trading.