How do Interest Rates Affect Currency Exchange Rate?
Interest rates play a critical role in shaping the values of different currencies. Central banks worldwide utilize interest rates as a monetary policy tool to manage their economies, making it imperative for traders and investors to understand the impact of interest rates on currency exchange rates. This article explores why interest rates matter in the realm of currency exchange rates, with a particular focus on the relationship between interest rates and yield differentials.
Interest rates and yield differentials
“Arguably the interest rate in a country is the biggest driver of currency exchange rates,” says Clive Ponsonby, former forex trader at J.P.Morgan and author of Currency View, a monthly research series on currency trading.
“In simplistic terms the higher the interest rate, the better return you get by owning the currency and so you are more likely to want to own that currency – the converse being true with lower rates.” This increased demand for the currency strengthens its value against other currencies. Conversely, when a country lowers its interest rates, it becomes less attractive to investors, potentially leading to a depreciation in the currency's value.
But note that this relationship between interest rate and currency exchange rate sometimes breaks down. “Notable examples will be the recent rate hikes by the Bank of England and Norges Bank in June,” says Ponsoby. “Both hiked more than median expectations, and in both cases the currencies actually fell over the next 24 hours.”
Anticipation of interest rate decisions
Forex traders closely monitor interest rate decisions made by central banks as they provide crucial insights into the future direction of currencies. Anticipating interest rate hikes or cuts can present significant trading opportunities.
“To some extent we see this all the time,” says Ponsonby, “The dollar strengthens when the Federal Reserve is hawkish. Additionally, economic data often serves as a proxy for interest rates, as higher inflation may result in currency appreciation, given the expectation of more rate hikes being priced in.”
By identifying countries with rising interest rates, traders can potentially benefit from currency appreciation by buying that currency. Conversely, identifying countries with falling interest rates can help traders short sell their currencies, capitalizing on potential declines in their value.
Carry trade
Yield differentials, which are the differences in interest rates between two currencies, drive investment flows in forex trading. When there is a significant yield differential between two countries, investors are motivated to seek higher returns by buying the currency with a higher interest rate and funding it with the currency with a lower interest rate. This strategy, known as the carry trade, allows traders to profit from the interest rate differential.
For example, if the interest rate in Country A is 5% and the interest rate in Country B is 2%, investors may borrow in Country B's currency at 2% and invest in Country A's currency, earning the 3% interest rate differential.
However, it is important to note that the carry trade strategy comes with its own set of risks. In particular, if the value of the borrowed currency, known as the funding currency, strengthens against the currency being invested in, the carry trade can become unprofitable. The appreciation of the funding currency reduces the gains from the interest rate differentials, offsetting or potentially surpassing the returns earned.
Conclusion
Interest rates are a crucial factor in forex trading, shaping currency valuations through their influence on yield differentials. By closely monitoring interest rate decisions and understanding the relationship between interest rates and currencies, traders can make more informed decisions and potentially capitalize on trading opportunities. Recognizing the impact of interest rates on yield differentials and the carry trade strategy equips traders with valuable insights to navigate the dynamic and ever-changing foreign exchange market.
More from Hedder:
Currency View, a monthly research series on currency trading
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.