Currencies and Interest Rates

If the guiding principle in real estate is “location, location, location,” in currency trading it’s “interest rates, interest rates, interest rates.” The most significant overall determinant of a currency’s value relative to other currencies is the nature and direction of monetary policy set by a country’s central bank. This is because monetary policy is aimed at influencing domestic interest rates, which drive currency rates relative to other currencies with different interest rates. Domestic interest rates also influence overall economic activity, with lower interest rates typically stimulating borrowing, investment, and consumption, while higher interest rates tend to reduce borrowing and  increase saving over consumption.

Interest rates are important to currencies because they influence the direction of global capital flows and serve as benchmarks for what investors expect to earn investing in a particular country This situation applies most directly to fixed income investing (bonds), which comprise the lion’s share of investments, but it also influences equity and other investment flows. All other things being equal, if you could invest in a government-backed bond that yields 6 percent or one that yields 2 percent, which would you choose? The one with the higher yield, of course. And that’s exactly what happens with currencies. Currencies with higher yields (higher interest rates) tend to go up, and currencies with lower yields (lower interest rates) tend to weaken.

Although we’ve stressed interest rates as one of the primary drivers of currency rates, interest rates are not the only determinant of currency values. Plenty of other elements come into play, affecting currency rates both in short-term trading and in long-term trends. To use an analogy, think of the stage in a theatre. Now think of interest rates as being the backdrop and the lighting on that stage. Various actors come and go; sets and props are changed between acts; but all the action on the stage takes place against the backdrop and under the lights. Interest rates provide the backdrop and set the lighting for most major currency movements even if they’re not always the center of attention.

Interest rate expectations

It’s not just the current level of interest rates that matter. Markets are always adjusting to changing circumstances and anticipating future developments. When it comes to currencies and interest rates, forex markets are focused more on the direction of future interest rate moves (higher or lower) than they are on the current levels because they’re already priced in by the market. So even though a currency may have a low interest rate, market expectations of higher interest rates in the future frequently will cause the currency to appreciate. The opposite is also true - a currency with a relatively high interest rate frequently weakens if the market expects interest rates in that country to move lower in the future.

The outlook period, or the time frame in which markets are expecting interest rates to change, can span several months or quarters into the future. The farther out the expected changes are on the horizon, however, the more limited the impact on the currencies in the here and now. Speculation on interest rate levels six months out tends to prompt relatively small adjustments that are frequently lost in the day-to-day noise. But as the timing for anticipated interest rate changes nears, currency speculation will reach a crescendo in the immediate run-up (weeks and days) to the anticipated change.

Sudden shifts in interest rate expectations

Another relatively common dynamic is for interest rate expectations to shift suddenly based on a single economic data report or only a few of those reports. For example, market opinion may be biased toward expecting an interest rate cut in a particular country, based on recent economic data and perhaps even comments from monetary policy officials. However, a surprisingly high inflation or strong growth report could reignite speculation that the next move will be to raise interest rates. In this case, market sentiment just swung 180 degrees, and the currency is very likely to see a similar rebound.

Interest rate cycle peaks and troughs

The most pronounced shifts in currency values typically come at the end of monetary policy cycles. To give you a quick illustration, when interest rates have been moving lower in a particular country for a period of time, there comes a point when rate cuts come to an end and the cycle reverses. Markets are expecting the next change in interest rates to be an increase. Although the market may be uncertain as to the exact timing of the first interest rate increase, it’s in the nature of markets to anticipate and speculate on that timing.

At the minimum, this shift in expectations is a signal to speculators who have been selling the currency with falling interest rates to begin to reduce their bets. As the picture of a trough in interest rates becomes more apparent, speculation will increase that the next move will be up; more bets are taken off the lower interest rate table, and new bets are opened speculating on an increase in interest rates. The impact on the currency can be substantial over time and frequently initiates a change in long-term trends.

Relative Interest rates

You may be tempted to focus strictly on the level of a currency’s interest rate as the basis for deciding whether the currency should move up or down. But currency traders usually pay very little attention to absolute interest rates and prefer to home in on one currency’s interest rate in relation to other currencies’ interest rates. One of the more popular (though potentially risky) long-term trade strategies, known as a carry trade, is based on relative interest rates.

Interest-rate differentials

In currency trading, markets are always focused on currency pairs, or one currency’s value relative to another currency. In this case, the difference between the interest rates of the two currencies, known as the interest-rate differential, is the key spread to watch. An increasing interest-rate differential will generally favor the higher-yielding currency, while a narrowing interest-rate differential will tend to favor the lower-yielding currency.

Some of the largest currency swings occur when two countries’ interest rate cycles are moving, or are thought to be set to move, in opposite directions. By focusing on the interest-rate differential, you can see that the divergent interest rate changes amplify the impact of interest rates. Instead of one currency appreciating on the basis of an expected 1/4 percent increase in rates, the second currency of the pair will also depreciate based on an expected  1/4 percent cut. Net-net, you're looking at a 1/2 percent change in the interest-rate differential instead of just a  1/4 percent change.

Traders should monitor the interest-rate differentials among the major currencies on a regular basis to spot shifts that may not otherwise be evident. For example, U.S. bond yields may rise by 5 bps (basis points, or a hundredth of 1 percent) - not an unusual daily development. Around the same time, Australian bond yields may move 5 bps lower - a gain, nothing earth shattering there viewed on its own. But add the two together and you’re looking at a 10 bps move between the two, and that’s something to pay attention to. If the same thing happens again the following day, now you’re looking at a 20 bps change in the differential, which is nearly equivalent to a typical 25 bps interest rate change from a central bank. You can be sure that if the Reserve Bank of Australia (REA) unexpectedly cut interest rates by 1/4 percent, or the Fed surprised everyone by raising rates by  1/4 percent, there would be some sharp swings in AUD/USD. The same holds true for changes in the interest-rate differentials.

Nominal and real interest rates

The interest rate to focus on is not always just the nominal interest rate (the base interest rates you see, such as the yield on a bond). Markets focus on real interest rates (inflation-adjusted rates, which is the nominal interest rate minus the rate of inflation [usually consumer price index]). So even though a bond may carry a nominal yield of, say, 8.5 percent, if the annual rate of inflation in the country is 4.5 percent, the real yield on the bond is closer to 4 percent.

This phenomenon is most evident in emerging market economies facing hyperinflation. Even though nominal interest rates may be 20 percent, if the annual rate of inflation is 25 percent, the real yield is -5 percent. Hyperinflation and negative yields lead to capital flight. The result is extreme weakness in the domestic currency, even though nominal interest rates may be extremely high.

The same can be true with very low interest rates and deflation (negative inflation), such as what happened in Japan over the past decade. With interest rates at very low levels, eventually zero, and facing deflation, real Japanese yields were significantly higher than the nominal zero rates on offer. (Remember: If you subtract a negative number, it's the same as adding that positive number.) As a result, the JPY experienced overall appreciation in this period despite very low nominal rates and abysmal economic prospects.