Deciphering the Effect of Interest Rates on the Foreign Exchange Markets

All of the different economic marketplaces are interconnected when considering the global economy. A decline in the stock market will therefore affect the whole bond market since money is shuffled back and forth between equities and bonds. This can be seen when looking at investors trying to pull their money out of a bear market in need for somewhere else to put it. It is this excess capital that winds up purchasing corporate or municipal debt. Likewise, inflation can have an effect on real estate with the raising or lowering of interest rates. When interest rates go higher, home buyers are able to afford less, which sends prices south. Another marketplace that interest rates can affect is the Foreign Exchange Market (forex).

Interest rates in the United States economy can affect the forex market mostly by helping funnel money in and out of foreign investments overseas. When interest rates are low, investors can often turn to foreign investments such as the bond markets of other countries. When the stock market crashed in 2000, for example, most of its investors shifted their focus from trying to maximize their returns to preserving what capital they had left. The logical place to turn seemed to be the government bond market, but interest rates were hovering around two percent, and were predicted to drop even more. Australia at the time was offering government debt with an interest rate of about five percent, even though the risk was about the same there as it was in the United States. Naturally, a lot of money flowed into Australia at that time, since investors wanted to buy bonds in the denomination of the then stronger Australian dollar. When a large amount of money is shifted from one currency to another, it affects prices of things because of a large shift in supply and demand.

The discrepancy in interest rates between the two countries that followed these events led to the development of an investment strategy, known as the “carry trade”. In this approach one would borrow money in a currency that has a lower interest rate, and converts it into the denomination of a country that had higher interest rates at the time. The investor then could buy bonds with the new currency, and collect the difference. This strategy had proven to be very lucrative for some, as long as the exchange rate stayed constant. For the individual investor, however, it was more difficult and expensive to do this because of the required transfers of money to different countries. This was designed primarily for the benefit of large institutions such as hedge funds and investment banks.
 

This does not mean, of course, that the individual investor can not take advantage of these discrepancies. There is something known as “yield spreads”, which dictates that by observing patterns in currency prices that are created by interest rate changes one can make some money. Since prices are affected by the flow of money into and out of a currency, the knowledge of a situation that is favorable for a carry trade can tell the investor where the institutional money is likely to go, and therefore which will ultimately raise the price of the target currency. As most forex trader know, the price of a currency relative to another is often directly related to the difference between the interest rates of the two countries. Using the example of Australia and the United States, if one plots the value of the Australian dollar in U.S. dollars over the course of several years, along with the yield spread during that time, the two lines on the chart are almost mirror images of one another. This is a fact that can, and should, be used to make a profit.

For the individual investor, paying attention to interest rate changes in the global economy can better arm in making trading decisions. As the yield spread is usually an indicator of one currency’s price relative to another, if one has an idea where interest rates are headed, one can be able to predict the rise and fall of forex prices, and make money off of those predictions.