Interest rates are by far the hottest topic in the forex world. They have a direct effect on the prices of the currencies. Nothing affects the prices more than interest rates. To sum it up, interest rates are the isht in the forex market!
When a country raises its interest rates, its currency will strengthen.
When the interest rate falls, it has a negative effect on the currency.
The interest rate is the price that is paid by those who borrow money. It refers to the percentage of an amount of money that was borrowed that is paid to the lender.
Why does a country’s currency get stronger when interest rates are higher? Because investors seek more of that currency in order to profit more. The moment a particular country’s central bank increases interest rates, investors take this opportunity to shift their money into that country.
Here is an example to make it all easy for you. Let’s say that Brad Pitt is a world-known currency investor. Angelina Jolie and Jennifer Aniston are each representative of a central bank, taking care of their own currency (popularity). The number of kids can be referred to as interest rates.
It’s the year 2005, and Brad Pitt, who is in invested in Jennifer Aniston, wants to have kids (higher interest rates). Jennifer doesn’t want kids (low appetite to raise her interest rate). Angelina Jolie has more appetite to have more kids (appetite to increase her interest rates). Therefore, Brad decides to switch his investment to the one who will ultimately give him more profit: Angelina! And that is how Angelina’s assets get all over the media and, for better or worse, her currency rate rises.
Other Characteristics of Interest Rates
- Interest rates dictate the flow of global capital into and out of a country because investors would rather invest in a country with a higher interest rate.
- Interest rates help gauge the status of a country’s economy.
Summary: where do you want to park your money? In a country that gives you a higher interest rate! So you start buying more of that currency, and that is how that country’s currency gets stronger.
Do Rising U.S. Interest Rates Always Imply A Stronger Dollar?
Here is a catch. The US dollar can be an exception in the interest rate rule for currency values. While we have heard in the past “The U.S. Federal Reserve… confirmed its determination to push U.S. money market interest rates higher to support dollar,”*according to a study conducted by Douglas R. Mudd, such interpretation may be consistent with short term analysis but not necessarily always true; especially in the recent years and during financial crisis.
According to this study “If the expected rate of U.S. inflation increases because of a sustained acceleration in U.S. money stock growth (while foreign expected rates of inflation remain relatively stable), U.S. interest rates will rise relative to foreign interest rates. The faster pace of U.S. money stock growth also will produce an increase in U.S. spending growth, which, in turn, will result in a depreciating foreign exchange value of the dollar.
If the higher expected rate of U.S. inflation also results in an offsetting decline in the expected value of the dollar on foreign exchange markets, no capital inflow will be induced by the rising differential between U.S. and foreign interest rates. Conversely, a sharp deceleration in U.S. money stock growth (not matched by equally restrictive foreign monetary developments) will produce an appredation of the dollar. In this case, initially U.S. interest rates will rise relative to foreign rates and U.S. spending growth will slow. As a result, the supply of dollars on foreign exchange markets will fall (as U.S. residents reduce spending for foreign goods, services, and securities) relative to the demand for dollars (as foreign investors increase purchases of U.S. securities in response to thehigher U.S. interest rate).
However, if the slower U.S. money stock growth is sustained and the expected rate of U.S. inflation is revised downward, U.S. interest rates will decline relative to foreign rates. Further, if the restrictive U.S. monetary actions also produce large upward revisions in the expected future value of the dollar, no capital outflow will result from the declining U.S.-foreign interest rate differential. In this case, an appreciation of the dollar on foreign exchange markets will initially be associated with a rising U.S.-foreign interest rate differential.
Eventually, however, the interest rate differential will decline while the dollar continues to appreciate.”
So next time you hear that the U.S. is increasing its interest rates, don’t jump into a buy position for the U.S. dollar. Check in with other points of the Invest Diva Diamond, and listen to credible market news analysts before making a final trading decision.