Education

How Interest Rates Affect The Value Of Currencies

As forex traders, we keep our ears to the ground, waiting to catch any rumours or whispers concerning changes to interest rates and try to determine the significance of any interest rate decision. 

With this article, we’ll examine the various effects of interest rates and interest rate changes on the forex market and other asset classes.

What are interest rates?

Before jumping in, let’s reflect on what interest rates are and consider why they should concern forex traders.

When we talk about interest rates, we don’t mean interest rates paid on loans, mortgages, credit cards, or interest earned on deposits or savings. What we mean is the central bank interest rate. For example, in the US, it would be the Federal Funds Rate, set by the Federal Reserve Bank (FED); in the UK, it would be the Bank Rate set by the Bank of England (BoE); in the Euro-zone, it would be the marginal lending facility rate set by the European Central Bank. All three of the aforementioned central banks maintain interbank lending rates of between 0% and 0.25%. 

Why are interest rates significant?

As we know, banks receive deposits from some customers and loan money out to other customers. Banks also need to maintain a capital adequacy ratio or a cash reserve ratio. If the ratio drops below a certain level, the bank will violate regulations and be punished by authorities. In a nutshell, if a bank lends out too much money, they can just borrow some money from another bank to top up their capital or reserve ratio. 

If interest rates are low, banks know they can loan out lots of money, knowing it will be cheap if they need to borrow additional funds. 

However, if interest rates are high, they will be more conservative with lending, as it will be more expensive to borrow from the interbank market. Lenders will adjust their lending approach by marking up interest rates and trying to only loan funds deposited by their customers, often increasing interest paid on deposits to encourage saving and compete against other banks.

How banks set interest rates

Each country’s central bank controls its monetary policy through the short-term interest rates at which banks can borrow from each other. Rates are cut to encourage lending and discourage spending, therefore injecting money into the economy. Rates are increased to curb inflation by making it more expensive to borrow and more compelling to save. 

Most central banks, such as the FED and BoE, have target inflation rates of 2% per year. Interest rates are one of the main tools to stimulate and prevent inflation. The indicators that central banks will generally use to decide their moves are:

  1. The Consumer Price Index (CPI)
  2. Consumer spending
  3. Employment statistics
  4. Housing market
  5. Subprime market

What happens when interest rates vary between countries?

When there is a considerable disparity between countries’ interest rates, it offers an opportunity to borrow one currency cheaply, invest it elsewhere, and earn interest payments. These kinds of arbitrage situations are usually short-lived. Though investors can try to borrow a currency with low-interest rates to invest elsewhere with high-interest rates, these opportunities are few and far between. Interest rates have remained incredibly low worldwide since the 2008 financial crisis. In light of the ongoing pandemic crisis, interest rates are expected to stay low for many more years. 

For old times sake, here is an example of what it would have looked like supposing it’s still possible to arbitrage interest rates.

Before the 2008 financial crisis, Australia had interest rates as high as 7%, whereas Japan had interest rates of 0.4%. The interest rate differential demonstrates how it would be much cheaper to borrow Japanese yen, convert it to Australian dollars and deposit with a bank in Australia to collect interest payments.

While doing this type of arbitrage, traders would be exposed to currency exchange risk. This was solved by covering the trade with a derivative, such as a forward contract. 

Earning interest on deposits or government bonds is the lowest risk way to make money. This is why if interest rates are higher in one currency, investors will park their capital in bonds and fixed deposits of this more desirable currency and not hold it in currencies with low or even negative interest rates. 

Interest rates influence supply and demand

Supply and demand is the ultimate force in the market. As illustrated in the previous section, there is naturally more demand for currencies where you can earn higher interest payments by merely depositing it and less demand for currencies where you won’t receive any interest. 

If the masses sell their JPY to buy AUD, it affects the AUD/JPY by increasing the supply of JPY; as the demand doesn’t exist, it pushes the value down. Concurrently, the demand for AUD increases, driving the value up.

Interest rates are not omnipotent

Interest rates alone do not determine a currency’s value. The perception of an exchange rate with other currencies results from several interconnected elements reflecting the country’s overall economic condition with respect to other nations. 

Perceived political and economic stability combined with the demand for a country’s goods and services also play a crucial part. Exports and trade balances indicate demand for products and services, leading to currency demand. GDP (Gross Domestic Product) and its fluctuations over time will suggest if a country is economically stable.

Currency printing and debt levels can help with the local economy’s short-term management, but it leads to inflation and potential currency devaluations when continued over time.

How to interpret interest rates

Interest rates can be interpreted in various ways depending on the context. 

Low rates can be seen as a response to a sluggish economy, but cheap credit is good for businesses and consumers. When there is perceived political and economic stability, the currency usually reflects this stability in its valuations. 

High rates are great for savers, but reduced consumer spending and business loans limit economic development; businesses lose revenue and are unable to get financing for expansion. 

Therefore you really cannot look at interest rates in isolation.

The US dollar’s exception

The US dollar holds the position of the world’s reserve currency. It’s also the quote currency for all major stocks and commodities. Due to the United States’ political and economic stability, the dollar is viewed as a safe-haven currency. Therefore, the USD has an unusually favourable exchange rate compared to other nations. This position is more important than interest rates, inflation, and other considerations when looking at its relative value compared to other currencies. 

Trading on rates changes

Forex traders should follow the news and stay on top of changes in fundamentals and central bank decisions. Changes to the central bank any policy can trigger short term volatility or initiate trend changes. With these moves comes the opportunity to gain from both carry trades and market fluctuations. Good research and analysis can help avoid surprises.  However, when these do inevitably happen, a trader should know in which direction the market could move:

  • Rate hike: The affected currency may appreciate, meaning traders will buy
  • Rate cut: The affected currency may depreciate, meaning traders will sell

Summary

Interest rates have a significant impact on both currency prices and inflation; however, it is not the only factor that we must consider when evaluating trading opportunities. When we find rare arbitrage situations to gain by borrowing one currency cheaply and investing in another with better rates, we should take advantage but be mindful of any economic changes.