Interest Rates and Forex: The Mechanism That Moves Currency

In the realm of finance, interest rates are usually the first culprit to examine for sudden currency collapses or spikes. You don’t need an advanced degree to understand interest rates and currency value. After reading this, many of the currency market anomalies will make much more sense.

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Basic Idea: Money Chases Returns

Here is the simplest way to understand the relationship between interest rates and currency value. It can be summed up in one phrase: money moves to where it earns the most.

Imagine you lost the will to be a good citizen and decided to be an evil banker instead. Your bank savings offer you a measly 1% interest. However, your evil self knows that in the neighboring country, the bank offers 5% interest.

Your evil self would definitely want to withdraw your savings to the neighboring country’s bank. Good institutions, investors, hedge funds, and banks operate on this level, and do so very often. This happens on a large scale.

You must first trade for that country’s currency if you plan to trade in another country. If everyone wants to do business in that country, then that currency will be worth more. This is why forex traders pay close attention to central bank decisions.

How Do Interest Rates Affect Currency?

In economics, everything is interconnected with interest rates and currency. There are several ways to examine how interest rates impact currency.

Direct investment flows

If a central bank’s interest rates are raised, it will entice foreign investment since the bonds and savings in that country will be more attractive. Foreign investors will purchase that currency. Higher demand equals higher currency value.

Expectations and speculation

Markets move based on predictions. Traders buy currencies they expect central banks will increase interest rates on. Because of this, expected movement occurs before the actual rate hike. Currencies can even drop on the actual hike as the situation was already expected.

Inflation connection

Rate hikes and inflation are closely linked. Central banks use rate hikes as a tool to combat inflation. This also makes currencies more attractive and more stable, as lower inflation will stabilize a currency. Rate hikes can also strengthen a currency through the direct yield appeal line and inflation.

Economic confidence signal

If central banks increase rates, it also shows that they believe the economy can sustain the higher borrowing costs. This belief also draws in foreign investment and strengthens the currency further.

All of these mechanisms work in reverse too. Rate cuts will typically weaken a currency by making it less attractive to hold.

Rate Differential Trading: The Strategy Built Around This

After you understand the relationship of rates and currencies, you can understand the strategy that is most widely used in forex: rate differential trading, also known as the carry trade.

The idea of most carry trades is very straightforward. You borrow money where interest rates are lower, exchange it for currencies where interest rates are higher, and keep the difference.

Let’s understand with an example: the Japanese Yen has lower interest rates than Australia. So, trading from Yen to Australian dollars is considered a good carry trade because you can potentially profit off higher interest rates in Australia. To increase the potential profit of a carry trade, a trader can take position sizes that are larger than normal.

The risk of this trading system is that currency exchange rates can potentially move in the opposite direction. If the currency with the higher interest rate falls in value, it can end up costing more than what is earned through interest and can eliminate profit as well.

This is the part that confuses people. Higher rates usually pull a currency up over time, but usually is not the same as always. In the short run a high-rate currency can still fall, and that is where the carry trade makes or loses money.

This system of trading works best in calm and stable markets, which is the opposite of what happens during a global crisis. During a global crisis, traders move their investments to more stable currencies, and the carry trade system collapses.

Carry trades contribute to a considerable amount of currency exchange in the market. They are responsible for the currency market behavior of the Yen and Swiss franc compared to other higher-yielding economies.

Central Banks That Set the Game

Every major currency pair has a central bank behind it. The Fed controls the US dollar. The ECB manages the euro. The Bank of England oversees the pound. The Bank of Japan handles the yen, and so on.

At these meetings, which typically occur about eight times a year, leaders will discuss different trends in the economy. They will decide if rates will be increased, decreased, or left as is. Forex markets analyze all the details that come out of these meetings, and the statement given after the meetings.

There are several things traders analyze:

• Rate Decision
• Statement
• Press Conference
• Forward Guidance

Traders use this information to predict what the forex market will do in the near future. As an example, “hawkish” language will likely lead traders to believe there will be a rate hike in the future, leading to an increase in the respective currency.

Understanding the cycle is even more important when dealing with the top three market trades: the EUR/USD, the USD/JPY, and the GBP/USD.

Economy Trends and Forex Rates

The correlation of interest rates and forex markets has been evident many times throughout recent history.

When the Federal Reserve began to increase interest rates aggressively in 2022, the value of the US dollar increased relative to all other major currencies. This was expected; US assets began to return better than any other, and the world began to invest in the US and the dollar.

When central banks shift from increasing rates to decreasing them, the value of the currency tends to decrease in anticipation of the pivot, and the decrease often occurs ahead of the actual cuts.

This is a repeating pattern. The same mechanism is always applicable.

In a Nutshell

This model tells a lot about trading, but not all. Factors outside of rates, like trade data and unexpected events in the market, can impact your trades. When you get to a point of crowded trades in the same direction, you will notice an irrational market.

Forex and interest rates are the best framework for understanding the movement of currencies. In fact, using this framework allows you to anticipate the direction of major macro trends.