ICT Mentorship Core Content - Month 05 - Interest Rate Differentials

Summary

This lesson from the January 2017 ICT mentorship focuses on interest rate differentials as a fundamental basis for currency trading. It discusses how higher yielding currencies are bought against weaker ones, using the Reserve Bank of New Zealand and the Federal Reserve as examples. The importance of aligning with central bank interest rates and using technical indicators like support levels and open interest is emphasized for long-term macro trades.

Takeaways

• 📈 Interest Rate Differentials: The script emphasizes the importance of looking at central bank interest rates to identify currency pairs with a significant interest rate difference for potential trading opportunities.
• 🌐 Global Currency Interest Rates: It suggests using resources like fxstreet.com to obtain a list of global currency interest rates, which can be a starting point for macroeconomic analysis.
• 🏦 Central Banks as Fundamentals: The script highlights that interest rates set by central banks are a fundamental basis for buying or selling a currency, indicating the strength or weakness of an economy.
• 🔑 High Yielding Currencies: It points out that funds tend to seek high-yielding currencies like the Australian or New Zealand dollar, which offer higher interest rates compared to others.
• 📉 Low Yielding Currencies: The script identifies low-interest-rate currencies such as the Japanese yen, Swiss Franc, and the Euro, which may indicate economic weakness or lower potential returns.
• 🤑 Money Seeks Yield: The concept that capital naturally moves towards higher yields is used to justify buying strong currencies and selling weaker ones.
• 📊 Technical Analysis: The script mentions the importance of using technical analysis tools like support and resistance levels, seasonal tendencies, and open interest to confirm trading setups.
• 📈📉 Forex Pair Selection: It explains how to select a forex pair for trading by coupling a high-interest-rate currency with a low-interest-rate currency, such as the Australian dollar with the US dollar.
• 📚 Smart Money Clues: The script advises looking for 'smart money' indicators such as significant changes in open interest, which can signal large-scale trading activity by institutional investors.
• 🌟 Long-Term Perspective: It stresses the use of a long-term macro perspective for trading, focusing on fundamental reasons and technical confirmations for significant price movements.
• 🚫 Avoid Exotic Pairs: The script advises against trading exotic currency pairs due to their higher risk and recommends focusing on major currency pairs with clear interest rate differentials.

Q & A

What is the main focus of Lesson 2.3 in the January 2017 ICT mentorship?

The main focus of Lesson 2.3 is on interest rate differentials and how they relate to central bank interest rates, and their impact on global currency trading.

Where can one find a list of global currency interest rates from central banks?

A list of global currency interest rates can be found on websites like fxstreet.com, which is mentioned in the script as a source.

Why are central bank interest rates considered fundamental in macroeconomic trading?

Central bank interest rates are fundamental in macroeconomic trading because they directly influence the attractiveness of a currency for investment, with higher interest rates often leading to increased demand for that currency.

What is the significance of the Reserve Bank of New Zealand's interest rate in the context of the script?

The Reserve Bank of New Zealand's interest rate is highlighted as the highest among the listed central banks, making its currency potentially attractive for yield-seeking investors.

Why would a trader consider the interest rate differential between the Reserve Bank of Australia and the Bank of Japan?

A trader would consider the interest rate differential to identify potential trading opportunities, as the higher interest rate of the Reserve Bank of Australia compared to the Bank of Japan could indicate a stronger currency performance.

What does the script suggest about the Bank of Japan's and the Swiss National Bank's interest rates?

The script suggests that the Bank of Japan and the Swiss National Bank have lower interest rates, which could indicate a weaker currency and potentially less attractive investment opportunities compared to higher interest rate currencies.

How does the script relate interest rate differentials to the selection of forex pairs for trading?

The script relates interest rate differentials to forex pair selection by suggesting that traders should look for a currency with a high interest rate to pair with one with a low interest rate, aiming to buy the high-yielding currency and sell the low-yielding one.

What is the role of 'smart money clues' in confirming a trading setup according to the script?

Smart money clues, such as seasonal tendencies or changes in open interest, are used to confirm a trading setup, indicating that large commercial traders are taking positions that align with the fundamental interest rate differential analysis.

Can the interest rate differentials be used for short-term trading strategies as suggested in the script?

The script suggests that interest rate differentials are more applicable to long-term macro trades rather than short-term strategies, as they are more indicative of large fund movements and fundamental economic trends.

What does the script imply about the importance of technical analysis in conjunction with interest rate differentials?

The script implies that technical analysis, such as identifying support and resistance levels, is crucial in conjunction with interest rate differentials to time entries and exits in trades effectively.

How does the script use the Australian Dollar and the Japanese Yen as examples for trading based on interest rate differentials?

The script uses the Australian Dollar as an example of a high-yielding currency to buy and the Japanese Yen as an example of a low-yielding currency to sell against, illustrating how interest rate differentials can influence currency pair movements.

Outlines

00:00

📈 Introduction to Interest Rate Differentials in Forex Trading

The script begins with an introduction to Lesson 2.3 of the January 2017 ICT mentorship, focusing on interest rate differentials and their impact on currency trading. It emphasizes the importance of starting with an understanding of central bank interest rates as a fundamental basis for currency selection. The speaker provides guidance on where to find a list of global currency interest rates and suggests that these rates are a crucial starting point for macroeconomic analysis. The lesson outlines the process of identifying high and low interest rate currencies and suggests that traders should consider buying high-yielding currencies and selling low-yielding ones, using the Reserve Bank of New Zealand and the Reserve Bank of Australia as examples of high-interest rate currencies, and the Bank of Japan and the Swiss National Bank as examples of the opposite. The speaker also mentions that the information provided in the notes will be rich with details on where to obtain and how to use this information.

05:00

🔍 Selecting Forex Pairs Based on Interest Rate Differentials

This paragraph delves into the practical application of interest rate differentials in selecting forex pairs for trading. The speaker illustrates how to pair a high-interest rate currency, such as the Australian dollar with an interest rate of 1.5%, with a lower-interest rate currency from the Federal Reserve, which at the time had a rate of 0.75%. The importance of considering the central bank rates as a fundamental basis for buying or selling a currency is highlighted. The speaker also discusses the use of smart money clues, such as seasonal tendencies and open interest, to confirm trading setups. An example is given where the Australian dollar, with its higher interest rate, is bought against the US dollar, particularly when the US dollar index shows signs of weakness and there is a significant reduction in open interest, indicating short covering by large traders.

10:02

📊 Utilizing Interest Rate Differentials for Long-Term Trading Strategies

The speaker continues with the theme of interest rate differentials, this time focusing on how they can be used to identify long-term trading opportunities. The paragraph explains how a higher yielding currency, such as the US dollar with an interest rate of 0.75% (adjusted from 0.50% after a rate hike), can be paired against a lower yielding currency like the Japanese yen, which at the time had a negative interest rate. The speaker uses the example of the USD/JPY pair, discussing how to look for strong resistance levels on higher time frame charts and waiting for smart money clues that indicate a sell-off. The importance of aligning with central bank interest rates and using technical analysis to confirm trade setups is emphasized, with the speaker providing an example of a significant price move in the USD/JPY pair following a resistance level break and a sharp decline in open interest.

15:04

🌐 Conclusion on the Role of Interest Rate Differentials in Currency Trading

In the final paragraph, the speaker wraps up the lesson by summarizing the importance of interest rate differentials in currency trading and how they can be used to identify significant price moves. The speaker encourages traders to review charts and analyze interest rate differentials between currencies, especially over the last six months, to understand the impact on currency pair movements. The paragraph also touches on the idea of yield spreads and their role in swing trading, suggesting that these concepts will be discussed in more detail in future lessons. The speaker advises against trading exotic pairs due to their inherent risks but encourages traders to look at the interest rate information from a central bank level and consider how it aligns with price action to identify potential trading opportunities.

Keywords

💡Interest Rate Differentials

Interest rate differentials refer to the differences in interest rates set by central banks of different countries. In the context of the video, these differentials are a fundamental aspect of currency trading, as they can influence the flow of investment between countries with higher and lower interest rates. The script mentions using interest rate differentials to identify which currencies are likely to appreciate or depreciate, with funds typically seeking to trade high-yielding currencies against low-yielding ones.

💡Central Bank Interest Rates

Central bank interest rates are the rates at which central banks lend money to commercial banks within their jurisdiction. These rates are a key monetary policy tool used to control inflation and stabilize currency values. In the video, the presenter discusses how these rates from various countries' central banks can be compared to identify potential trading opportunities based on the relative attractiveness of different currencies for investment.

💡Macro View

A macro view in economics and finance refers to the analysis of large-scale economic factors and their impact on a wide range of variables, including currency values. The video emphasizes the importance of starting with central bank interest rates when taking a macro view of currency trading, as these rates are fundamental indicators of a country's economic health and policy direction.

💡FXStreet.com

FXStreet.com is mentioned in the script as a source for obtaining a list of global currency interest rates from central banks. This online portal provides financial information and resources, including data on interest rates, which are crucial for the analysis discussed in the video. The presenter suggests using such resources to gather the data necessary for making informed trading decisions.

💡Yield

In the context of the video, yield refers to the return on an investment, specifically the interest rate earned on a currency. The script discusses how money seeks yield, meaning investors will typically buy currencies from countries with higher interest rates, expecting them to provide a better return on investment. This concept is central to the strategy of trading based on interest rate differentials.

💡Forex Pair

A forex pair is a currency pair traded in the foreign exchange market, representing the simultaneous buying of one currency and selling of another. The video script uses the term to describe how to select two currencies based on their interest rates to form a trading pair, such as the Australian dollar paired with the US dollar, based on the interest rate differential between the two countries.

💡Smart Money

Smart money in the context of the video refers to large institutional investors or traders who are believed to have more information or insight into market movements. The script mentions looking for 'smart money clues' such as changes in open interest or seasonal tendencies, which can confirm trading setups and indicate the direction of large-scale capital flows.

💡Open Interest

Open interest in the financial markets refers to the total number of outstanding contracts that have not been settled. In the script, a significant reduction in open interest is used as an indicator of short covering by large traders, suggesting a potential shift in market sentiment and a move towards higher prices for a particular currency.

💡Support and Resistance Levels

Support and resistance levels are prices at which a security's price tends to stop falling (support) or rising (resistance). In the video, the presenter discusses identifying long-term support levels for the Australian dollar and resistance levels for the Japanese yen as part of the trading strategy based on interest rate differentials and technical analysis.

💡Long-Term Macro Trades

Long-term macro trades are investment strategies that focus on large-scale economic factors and aim to capture significant price movements over an extended period. The video script emphasizes the use of central bank interest rates and technical analysis to identify opportunities for such trades, which are more about capturing fundamental shifts in currency values rather than short-term fluctuations.

💡Dollar Index

The Dollar Index, or USDX, is an index measuring the value of the United States dollar relative to a basket of foreign currencies. In the script, the presenter refers to the Dollar Index to discuss the direction of the US dollar and its relationship with other currencies, particularly in the context of identifying trading opportunities based on interest rate differentials.

Highlights

Introduction to Lesson 2.3 of the January 2017 ICT mentorship focusing on interest rate differentials.

Importance of starting with a macro view and central bank interest rates for fundamental trading decisions.

Use of global currency interest rates from central banks as a basis for trading decisions.

The mention of fxstreet.com as a source for the list of global currency interest rates.

Explanation of how to use the list of interest rates to identify high and low yielding currencies for trading.

Identification of the Reserve Bank of New Zealand and Australia as having the highest interest rates.

Identification of the Bank of Japan and Swiss Bank as having the lowest interest rates.

Discussion on the fundamental basis for buying or selling a particular currency based on interest rates.

The concept of money seeking yield and its relation to high interest rate currencies.

The strategy of trading high yielding currencies against weak yielding ones.

Example of selecting a trading pair based on interest rate differentials, such as Australian Dollar and US Dollar.

Importance of technical analysis in conjunction with interest rate differentials for trading decisions.

Use of smart money clues like seasonal tendencies and open interest to confirm trading setups.

Analysis of the Australian Dollar's movement based on its high interest rate and support levels.

Explanation of the significant price move of the Australian Dollar after a reduction in open interest.

Strategy of looking for currency pairs with high and low interest rates for potential trades.

Case study of the US Dollar versus Japanese Yen pair and its movement based on interest rate differentials.

Discussion on the practical application of interest rate differentials in long-term macro trading.

Emphasis on using interest rate differentials with technical analysis for high probability trades.

Encouragement to analyze charts and interest rate differentials for the last six months to identify significant currency pair moves.

Advice on not trading exotic pairs but understanding the interest rate differentials for educational purposes.

Final thoughts on the simplicity and effectiveness of using central bank interest rates for fundamental trading strategies.

Transcripts

okay folks welcome back this is lesson

2.3 of the january 2017 ict mentorship

we're looking at interest rate

differentials

okay central bank interest rates

if we're going to be looking at a macro

view it really needs to start here

and there's several places on the

internet you can go to get this list but

this is the global

currency

interest rates from the central banks

this is the list you can get from

fxstreet.com

you do a simple google search and in the

notes for the pdf i'll have all the

links for all these things

even though they don't show up in the

actual presentations in your pdf file

like i said the notes will be rich with

details about where to get the

information from and what you can do

with it

but this list is from

fxstreet.com

and

what you want to do is

when you look at the list and obviously

it's a rather anemic

list of interest rates currently in the

current state of uh

the global economy

but generally there's always going to be

a

higher interest rate among another

currency versus another

country

and basically what you're going to do is

you simply look for

a currency or country in this case

that has a high interest rate

as you see here the highest on this list

is the reserve bank of new zealand

the second in the

high end of the interest rates would be

reserve bank of australia

and obviously the low end would be the

bank of japan

and the swiss bank

and

the european central bank at zero we're

going to go through this in

two passes in other words we're going to

find two trading examples on a higher

time frame basis using interest rate

differentials

starting with the interest rates that

are pegged at the central bank level

now again if we're looking at this this

is going to cut to what fundamental

basis there is to buy or sell a

particular currency

uh you can't get any more fundamental

than interest rates so

if we're going to look at these

countries

if we pick for instance

a currency that we want to be a buyer of

obviously money seeks yield so it makes

perfect sense to be a buyer of

australian

or new zealand currency

if you're expecting weakness in a

particular country or in a

country's economy

you can see that in the form of a weak

interest rate

for that particular currency or that

country

uh swiss national bank

bank of japan

european central bank

bank of canada

bank of england

even federal reserve really it's very

low end

on the interest rate curve

based on this list here

so if we were to

take a look at these countries

we could build a model on a higher time

frame basis

on long-term macro trades which have the

most opportunity to move

based on a fundamental

establishment of

interest rates being utilized for

the selection process

put in other words

funds will seek to trade high yielding

currencies

and place that

against a weak yielding currency

and they will look to buy strong

currencies and sell against weak

currencies and they will look to sell

against currencies and buy against

strong currencies in other words they're

going to be buying strong payers and

selling weak pairs

all right let's take a look at selecting

a pair for trading

first thing you do is you want to look

for a country that has a high interest

rate

then you want to select a country with a

low interest rate

it doesn't have to be the lowest of the

low it doesn't have to be the highest of

the high it can be just a very strong

difference between the two

interest rates

and then obviously once you select the

high end and the low end currency

or country in this respective currency

obviously

you're going to determine the forex pair

coupling based on those two

respective countries

for an example we're going to assume

that the australian dollar is our

selection for our high interest rate

yielding country

and the interest rate comes in at 1.5

percent

and we're going to pair that up with a

weaker currency from the federal reserve

which is the u.s market

with a 0.75 percent or three-quarter

point

now i'm going to have to remind you that

this data is

factored in with a interest rate hike of

25 basis points so

at the time of the trade we're going to

actually review the federal reserve

central bank rate was at 0.50

but when we look at this the way we

couple that up for a 4x pair

obviously the australian dollar

pair is what we'd be looking at

once we arrive at our currency that

we're going to be focusing on being a

buyer of buying strength against a

weaker currency for instance the dollar

index here

we're looking for strong support on a

higher time frame chart now we're

thinking long-term macro perspective

so we're only looking for

large moves in a fund level trend

following idea but before we get to that

point we have to expect

some sizable move that's going to be

positioned with

big flows behind it

again we're fundamentally aligning

ourselves with the central bank interest

rates

we're coupling a pair based on a high

yield interest rate 1.5 percent

versus a

half of one percent at the time of the

trade but in this case we have to show

the numbers as they are here now uh 0.75

percent

we wait for smart money clues that it's

being bought now we went through several

of those things that indicates that in

the mentorship so far

but we'll revisit a few of them for this

example

seasonal tendency and or open interest

can confirm this

so there's our two elements of smart

money tools that we can use it doesn't

have to use every possible scenario we

only need one or two to confirm

and we are looking for us dollar index

directional confirmation that qualifies

the setup

okay we're going to look at the

australian dollar

this is the cash price for australian

dollar

and we identified a long-term support

level old low in the form of 71.50

and we move over to our

march contract 2017 of australian dollar

which would be the active contract that

you would be trading at the end of

december 2016.

we're going to add that 7150 level on

our chart you can see price has traded

into that as support

now i want you to take a closer look at

what's going on with open interest

as you see open interest has been

declining

and notice this big reduction here

that purple line dropping like that

that's a massive reduction in open

interest open interest

is going to be a

indication that there's short covering

by way of the smart money or large

commercial traders

if they're short covering

that means that they're not trying to

assume the other side of the trade for

buyers they want to reset themselves

because they anticipate what if they

don't want to be short they're

anticipating sharply higher prices

and that's what you get here off that

71.50 now look at the look at the

magnitude of the move

seen

with the australian dollar here

remember the payer that we're trading in

the forex market is aussie dollar all z

has

that higher 1.5 interest rate

the federal reserve was offering 0.50

to the latter part of december where it

was adjusted for another 25 basis point

pike

so now it's

at 0.75 percent for the federal reserve

rate it's still

half of the interest rate that's

yielding

on the australian central bank consider

how much this pair has moved

from the 71.50 level

400 plus pips have been

seen from this rally

off of a higher time frame support level

71.50 now just because it trades in a

higher time frame support level

doesn't mean that it's going to trade

higher

but when you couple that 7150 level

which is a higher time support level or

an old low

and you also notice that the market has

seen a sudden reduction in open interest

which is short covering on the part of

smart money

and you couple the idea fundamentally

that the higher yielding interest rate

of 1.5 percent from the australian

central bank

coupled against the weaker

0.75 percent or if you want to go back

and use the half of one percent rate

either way

you're getting

a higher yield off of the australian

currency

versus the

dollar

and that's why we've seen such a sharp

rally and why i have been talking about

the australian dollar going higher as a

basis of our teaching

throughout this mentorship we've been

talking about the australian dollar

going higher

with respective levels that have just

recently been hit with 75 80 as that

level that we just mentioned from last

week

the fundamentals if you will

okay were

aligned with the central bank interest

rate of one and a half percent coupled

against a weaker federal reserve

0.75

interest rate for the dollar when you

have that basis and you have technicals

to support it and you're looking at a

hard time frame chart like this it lines

your pockets with wonderful

opportunities to continuously take large

moves out of the marketplace and you

don't need to be trading a lot

by looking at these higher time frame

interest rate yield scenarios

coupling it with high odds probability

technicals you get yourself in sync with

the most significant price moves to are

going to most likely surprise many of

the neophyte traders

you can see also that we had a higher

high in the dollar index

when we fail to make a lower low in the

australian dollar

okay we're going to do another example

we're going to select a pair with a low

interest rate this time

and we're going to select a country with

a high interest rate

and we're going to determine the forex

pair that couples for that trade

in this example we're going to use a

higher yielding currency

0.75 percent

which again that was actually

half of one percent of the time when

this trade is being shown so i have to

adjust it show you for your notes

versus japanese uh economy and their

central bank rate was

negative

and the two respective

countries and their currencies would be

paired up in the form of

dollar yen

we're going to look for strong

resistance on higher time frame charts

we're going to wait for smart money

clues that it's being sold in other

words we want to see japanese yen hit

resistance levels and show indications

that it wants to sell off

and we're looking for seasonal

tendencies and or open interest to

confirm the trade

and looking for dollar index directional

confirmation to qualify the up so if we

have the expectation that the weaker

currency is the japanese yen

interest rate basis

against the stronger of the two

the dollar

which has the higher yielding central

bank rate

we're going to see that u.s dollar

versus japanese yen

pair

actually go higher

because you're buying dollar and selling

in so if we're expecting weaker japanese

yen because of the weaker lower interest

rate

that means that the pair we coupled for

foreign exchange trading

the dollar yen is the pair we'll be

trading so even though we're looking for

weakness in yen

we're looking for the opposite of that

for the pair the way it's formed so the

dollar yen pair is actually going to

strengthen or go up in our charts

as it relates to

the cash

you can see the weekly chart here

and a bearish order block

at the 9800 level

right here

and that would set the stage for a move

this is the cash price of the japanese

yen

and price trades up into that 90 big

figure

and weakness is seen from that point one

obviously

this is seen on the heels of the donald

trump election

but nonetheless this move

many hundreds of pips

well over 1200 pips of a price move

and again

it's based on

the

central bank interest rate

and the differential between the two

and by having that coupled

with strong technicals

seasonal tendency

understanding that the market was

expected high volatility because of the

election

this massive decline

seen in the cash price of japanese yen

is also

seen in the understanding because of our

analysis or my own analysis as we were

going through the mentorship

why i was calling the dollar yen higher

all those factors for

leading us up into

those

commentaries

this was the basis behind it all having

the higher yielding interest rate of the

dollar versus the weaker currency

interest rate of the yen

and coupling that with

the technicals that we teach or use in

the inner circle trader

repertoire

it gives you these massive price moves

based on a higher time frame premise

so you're using these things again

you're not using them to day trade

you're not using them to facilitate

short-term trades but if you trade in

that direction obviously your trades

will be a lot higher probability but

they're more inclined to

be used on a higher time frame basis

because

the large funds because of the nature of

their trading style their trend filing

in nature

they're going to look at fundamental

reasons to trade specific currencies

and if you look at the moves that's

transpired in the last three to six

months

all of the big moves come by way of the

information that's drawn by the

differentials that we've discussed so

far here and the method of using those

central bank interest rates

pegging them together to get

specific currency pairs

and having technicals align you'll be

able to see that footprint of large

flows and funds pouring money into a

particular currency

if you look at the

dollar yen pair in relationship to this

in november you would see a strong buy

or a low in that particular currency

pair

so we're going to talk more about

differentials we're actually going to

start talking about

yield spreads also when we get into

swing trading so there's other

information we're going to talk about

with interest rate differentials

and yield spreads but for now

go through your charts and look at the

interest rate differentials between

all the weaker and higher yielding

currencies on the central bank level and

look back over the last six months and

see what payers you see

and find through as a homework

excitement look for setups that took

place higher timeframe support

resistance levels institutional order

flow ideas open interests try to

incorporate that as well on support

levels

and then

justify why

in hindsight now this is a good exercise

go back in hindsight and justify why the

fundamentals were an alignment with

those significant price moves and again

you're looking back three to six months

for currency pair moves to take place

now i don't

tell people or even advise people to

trade

exotic pairs now exotic pairs would be

like uh

euro swissy okay or something like that

but

look at some of those currency pairs to

have a higher yielding interest rate

versus a lower interest rate okay and

how you would pair them up in a forex

pair and look at the respective price

action in the last three to six months

on those pairs

viewing the the information that we're

using from the central bank level at the

interest rate

again

this is a really simplistic approach to

trading long term

and it's coupled with

dare i say it again a fundamental

application of how the funds would go in

and move large scale

into a particular currency or out of a

currency based on the interest rate

information that we've covered here

today until next time i wish you good

luck and good trading