When you read about Exchange Rate forecasts you often also read about Interest Rate predictions. But what is the connection? In this article we explore the relationship between Interest Rates and Currencies.
The foreign exchange market (also known as FX or forex) is a global marketplace for exchanging national currencies (Investopedia). It is the largest and most liquid market in the world. According to a 2019 triennial report from the Bank for International Settlements, often called the “central bank for central banks”, the daily trading volume for FX reached USD 6.6 trillion as of April 2019.
Each country’s Central Bank determines short-term interest rates. In the U.S. for example, interest rates are determined by the Federal Reserve’s (US Central Bank) Federal Open Market Committee (FOMC). The FOMC meets 8 times a year to determine the near-term direction of monetary policy and interest rates. Actions of central banks like the Fed affect short term interest rates.
Interest rates have always affected the currencies and forex trading. Forex is ruled by many variables, but the interest rate of a currency is a fundamental factor that prevails. All other factors being equal, higher interest rates increase the value of one country’s currency relative to others offering lower interest rates. Higher interest rates tend to attract foreign investment, increasing the demand for that country’s currency.
Interest rates matter to forex traders because when the expected rate of interest rates change, the currency generally follows with it. This table (from IG Trading) displays the possible scenarios that come from a change in interest rate expectations:
|MARKET EXPECTATIONS||ACTUAL RESULTS||RESULTING FX IMPACT|
|Rate Hike ↑||Rate Hold →||Depreciation of Currency ↓|
|Rate Cut ↓||Rate Hold →||Appreciation of Currency ↑|
|Rate Hold →||Rate Hike ↑||Appreciation of Currency ↑|
|Rate Hold →||Rate Cut ↓||Depreciation of Currency ↓|
Interest rate differentials are simply the differences in interest rates between two countries. If one country has an interest rate of 3% and the other has an interest rate of 1%, it has a 2% interest rate differential.
The use of interest rate differentials is of particular concern in the foreign exchange markets for pricing purposes. If you were to buy a currency that pays 3% against the currency that pays 1%, you would be paid the difference with daily interest payments. (the balance -Understanding Interest Rate Differentials).
A term widely known among FX traders is the “carry trade.” This is when you buy a high-interest currency against low-interest currency and earn daily interest payments on the difference.
In 2014 developed countries (US, UK, Germany, Canada, France, Australia) took their interest rates around or below zero while emerging market currencies (Mexico, Argentina, India, Indonesia) raised their interest rates. They did it for different reasons. Developed market economies wanted to spur demand while emerging market economies were trying to limit capital outflow and economic instability.
While short term interest rates do not move much, the expectations on the direction and slope of rate changes may change weekly. A popular market for watching changing interest rate expectations is the 10-Year Government Treasury Debt market. The US 10-Year Treasury is the most liquid and widely traded bond in the world. Trading Economics publish a daily Overview of Global 10-Year Government Bond Yields where one can monitor the movements of each country’s yields against the other. (See below table)
Although interest rates can be a major influence on a currency’s value and exchange rates, the final determination of a currency’s exchange rate against other currencies is the result of other interrelated elements. It is to one’s advantage to keep up to date with the economic data using an economic calendar to forecast potential changes in market expectations.
Disclaimer: Please note any provider recommendations, currency forecasts or any opinions of our authors should not be taken as a reference to buy or sell any financial product.