Interest Rates & Currency Rates
When you trade in currency markets there are a multitude of factors to consider and analyse when deciding which currencies to trade, which to buy and sell, when to sell – and at what price.
Currency rates are influenced by:
- Macroeconomic data
- Expectations for the economies that issue the currency
- The overall state of the global economy
- Geopolitical influences
- The current and expected interest rates in the economy that issues the currency
Here we’ll discuss the impact that interest rate expectations have on currency rates.
How interest rates impact currencies and Currency rates
Generally speaking, when markets anticipate higher future interest rates, it’s likely to have a positive impact on the value of that country’s currency against others. The anticipation of lower interest rates in the future will likely encourage the opposite effect.
The main driving force for this correlation is that higher interest rates often encourage short-term capital inflows to an economy on the expectation of a better rate of return from a higher interest rate. A lowering of interest rates in the future would likely encourage an outflow of short-term capital, thereby pushing the currency lower against other currencies.
Interest rate influences
There are numerous factors that influence the current level and potential future level of interest rates. In the major global economies, the national or regional central bank sets interest rates and decides on interest rate levels in the future.
Central Banks are more likely to raise interest rates if they see the economy performing strongly and inflationary pressures become a concern. The objective is to stop the economy form ‘overheating’ and slow the pace of economic growth.
Conversely, if the economic situation is negative and the economy is expected to slow, the central bank may lower interest rates to stimulate the economy.
So when trying to decide on the future path of interest rates, you need to look at central bank decisions and statements, central bank meeting minutes, and views expressed by decision-makers on central bank policy committees.
By having an understanding of the future path of interest rates, you can also derive a view of the future path of the associated currency.
Interest rate differentials
The current and anticipated interest rate differential between any two economies is a significant factor in determining the currency rate.
Given that currency markets are relative value markets (e.g. trading on the value of one currency relative to another), it not just the level and direction of interest rates in any one economy that determines the price. It’s how the interest rate differential between any two economies is expected to change going forward.