Interest Rates Explained Like You Are 5

Imagine a massive cookie jar. Everyone wants a cookie, but there's a catch. The Cookie Monster gets to decide how easy it is for you to grab one. Weird, right? But stick with me. This'll all make sense in a sec.

Whether you're new to Forex or you've been trading since dial-up internet was a thing, you have to understand interest rates. You just can't ignore them. They're everything in Forex trading. Today, I'm going to break them down so even your 5-year-old self would get it. And on top of that? I'm making it actionable. Let's go!

Think of interest rates as the cost of borrowing money. Or, the reward for saving it. If interest rates are high, it costs more to borrow. If interest rates are low? It's like a buy-one-get-one-free deal. Interest is how the lender makes money.

One of the most common examples is mortgages, or home loans. You go to a bank and want $500,000. They give you this money over 30 years for you to pay back. Now, if you just paid back that $500,000, they wouldn't make any money! The interest is what they charge for the loan. So, you might pay an extra 5% per year on that loan amount. That's where they make their profits.

Interest rates mess with the economy's money situation and decisions. Think about it. You go to a vending machine. A can of Coke is $10. You're probably going to say no thanks, right? But if you see it's just $1, you might even buy three!

This works the same way in the economy, just on a much bigger scale. So, we have these big Financial Wizards called central banks. Their job is to control money flow within economies. Before we go all tin foil hat, yes, they control money flow. No, we're not diving into a conspiracy theory. It's just a central bank.

These Wizards, if they think the economy is too hyped, will raise interest rates. This cools off spending. It's like putting the economy in time out because it's been performing too aggressively. But, if the economy is looking sad, like The Loner, they lower rates, encouraging spending. It's like yelling "shots on me!" at a bar to get the party going again.

To recap:

Here's where it gets juicy, Forex pros know the deal. Interest rates drive currency strength. If interest rates are likely to go higher, the currency will probably gain strength. Why? Because investors want that sweet, sweet higher interest rate for that juicy money return.

If the U.S. raises interest rates and Europe keeps them low? No brainer. The dollar is just going to flex on the Euro. It's like choosing between a savings account that gives you 10% interest or one that gives you 1%. I'm hoping you're a good enough trader to recognize which one's going to be more beneficial.

When you go a little deeper, you uncover something called carry trades. That's when really smart investors borrow money from those lower interest rate currencies and use that money to invest in the higher interest rate currencies. Genius! But that's a story for another day. We can dive into carry trades in another video. For now, let's get back to Forex.

So, what happens when the Cookie Monster suddenly changes the rules of the cookie jar?

If rates go up, borrowing slows, spending stops, and currencies get stronger. The opposite happens if interest rates drop. Spending increases, and currencies may get weaker. Think of it like buying tickets to a concert. If you see prices have doubled, you're staying home. But if you see they're up for sale for five bucks, you're losing money by not attending.

So, as Forex traders, why do we care? Well, they're like a GPS. They guide currency strength and weakness. They can give you massive insights into where long-term and large amounts of money will flow.

As traders, we analyze central bank decisions. But we also look into things like inflation data, GDP, and unemployment rates. Because they can give us insights into what the Cookie Monster is thinking. How many cookies are in the jar? What's the demand for the cookie?

As traders, we bet on probabilities. We don't wait for the central bank to make a decision and then put our money there. We're already thinking 2, 3, 4 months in advance. By the time you've figured out the central bank is going to raise rates, it's probably too late. The move's gone.

So, we look elsewhere. We try and figure out where the risks of increase or dropping rates are. We place our money then. By the time the rate is being dropped, we've already made our money and we're on our way.

If you're interested in learning a little bit more about how to predict interest rates or even use the Futures markets to just blatantly show you where the market is predicting leave a comment below and we'll start chatting!

Let's bring it back up and give you the TLDR.

Not always. There are nuances. But that's a general rule of thumb. As traders, we live for those rate changes. That's where money can be made. A lot of traders think these fundamentals are too complicated. Too complex. But trust me, it's not magic. It's just how these economies work. If you understand how the asset actually works, you know how to position yourself. You make your job a lot easier.

There you go. Those are interest rates! Now go trade smart.