Though many factors impact the valuation of a currency, one crucial aspect to focus on is the country’s interest rates. With all things being equal, foreign-exchange traders must concentrate on interest rates more than anything else. Here, traders will know the meaning of interest rates and their impact on a country’s currency value.
Know What to Look For
Suppose there is a relatively stable geopolitical and economic situation globally. In that case, the currency market will naturally favor a currency with a rise in interest rates and further interest rate hike expectations ahead. But still, interest rates are only one of the factors that move a currency. Other factors include inflations, geopolitical concerns, war, correlations to other markets, and many more that can come into play.
As interest rates increase, it tends to lure many foreign investments. And this is because money will always go where it is treated the best.
A Scenario
For instance, you operate a large fund out of the United Kingdom. And you must place money to work somewhere. Now, the most natural place to put a significant amount of money is where you can find the most growth.
Usually, central banks will increase interest rates if an economy is running hot. Though there is a timing issue here, there might be a time where you may decide to go into a stock market – where you need to make purchases in a local currency. The higher rates were due to concerns about the economy boiling over. At the same time, there is a proclivity for stocks to surge in that situation. You decide that Germany is the place to invest worldwide, as many German multinationals have enjoyed significant export growth. And to buy stocks on the DAX, you should buy euros.
In that case, you obviously must buy the EUR/GBP pair. If the European Union presents a strong economy, you won’t just buy stocks in that environment; you will also seek to buy bonds. With that, you need to buy these in euros. This is the natural flow of money chasing the higher yield. You might face a scenario where the United Kingdom has an interest rate of 1.00%, while the European Union has an interest rate of 2.25%.
But after several months, the global situation changes drastically. It is the middle of a global recession, and you must do something with your money. This was the case during the financial crisis, which began to see the currency market act in a way that most people would’ve thought counterintuitive.
Then, the U.S. dollar began to gain over time after the initial stock rapidly. And this was due to a few places in the world that can adapt the type of transactions that the treasury market can in America.
For that scenario, there is an exodus of capital from countries worldwide into the treasury market, which pushed the value of the dollar forward. And this was counterintuitive because the interest rates are slashed quickly. Honestly, that environment is where people look to keep their money safe. And at that time, it wasn’t about earning some kind of field. It was all about protecting the large portfolios.
When things settle down, money managers will purchase other currencies like the New Zealand dollar or the Australian dollar. They might also look for emerging market currencies like the Turkish Lira and the South African rand. Then, the emerging market currencies became specifically attractive as some of the interest rates in those countries – although historically low for those places – were still five or six times what many of the developed economies globally were paying. If people began to feel like it was safe to enter that area again, that was the first place a lot of money goes.
Key Takeaway
Interest rates are the main driver in the value of currencies. However, most of it has to do with traders’ view on a political-economic level. The fast and dirty rule is that once people became comfortable, they buy higher-yield assets, such as currencies that pay higher yield during the swap. If they are not comfortable, lower interest currencies like the Japanese yen and the Swiss franc have historically done slightly better, right along with the greenback. Remember to prioritize understanding the risk appetite of the market, then follow interest rates in both directions.