Interest is a fee charged for borrowing cash. A more technical definition the interest – it’s a fee charged by someone who lends money to someone who borrows that money and an interest rate is the percentage rate at which that fee is charged. Interest rates are one of the major drivers of the Forex currency market.
The interest rates are normally set by a country central bank. In the USA, interest rates are set by the Federal Reserve Bank and for the Eurozone, the European Central Bank is responsible for setting the interest rates. The central banks use the interest rates to promote economic growth or to curb inflation.
Interest Rates Impact on Currency Market
But, how do interest rates specifically affect a country’s currency? When the central bank increases the interest rates, the cost of borrowing goes up. This means that homeowners now should pay more on their mortgages and as an effect, they have less money to spend on commercial goods. This forces the demand for these goods to go down.
In this scenario, goods manufacturers are now faced with lower demand for their products and they are unable to raise the price to cover the loss. Therefore, raising interest rates will curb the economy by decreasing the demand for goods and services and it will reduce inflation. However, when the economy needs a stimulus the central bank might want to decrease the interest rate to jump-start the economy.
Explaining Lower Interest Rates
When the interest rates are lower, homeowners spend less on mortgages and therefore have more money to buy other goods and services. These goods need to be produced so by lowering interest rates production will rise, and thus stimulate economic growth. It’s not just mortgages that are affected by interest rates; factories and other areas of industry borrow money to invest in growth. When interest rates are low the cost of borrowing is low, business owners will be more inclined to grow their business and will borrow money. This money is invested in the economy spurring further growth.
Explaining Higher Interest Rates
On the other hand, when interest rates rise business owners will not continue to invest as much because it’s more expensive for them to do so. The economy will slow down because less money is invested. A higher interest rate means that you gain higher rates of return for the money you hold in a savings account and therefore benefit those who have savings or control money supply.
Interest Rates and Exchange Rates
If one country has a higher interest rate than another country, money will flow into the country with higher interest rate because investors will get more return on their savings. Because the country with the low-interest rate currency is going to be exchanged for the country with higher interest rate currency, this increasing demand for the higher interest rate currency and this currency appreciates in value. In contrast, the lower interest rate currency tends to depreciate in value.
However, we should keep in mind that these simple straightforward relationships don’t occur very often in the real world as there are many factors in determining the intrinsic value of currencies.
Even though longer-term investors are more likely to favor currencies with higher interest rates, this is more likely to happen in an environment when we have a big divergence in monetary policy between two central banks. For example, the US Federal Reserve and the ECB are on opposite sides of the monetary policy spectrum. Firstly, we have the Fed which is the only major central bank to embark on a tightening cycle hiking rates for the first time since the 2007 financial crisis, and on the other hand, the ECB is pursuing an easing monetary policy.
Interest Rates Differential
The difference between one currency’s interest rate and another currency’s interest rate is known as the interest rates differential. If the interest rate differential increases it reinforces the higher interest rate currency, while a decrease in the interest rate differential reinforces the lower interest rate currency.
The interest rate differential is a key component of the carry trade. The carry trade is based on the idea of going long a currency with a higher interest rate and simultaneously selling a currency with a lower interest rate.
Interest rate announcements are an important news event and one that you should be paying attention to even though you’re not a fundamental trader because it can give you more clues to allow you to better forecast currency exchange rates. Interest rate announcements also affect the currency spread. To read more about the spread and what does a spread tells you can be found in our previous article here.
More important than the interest rate is the interest rate expectation. Usually, the currencies move in advance as the market tries to price in these changes in monetary policy. So as we approach an possible interest rate new event, watch the market for new trends to find new trading opportunities.