Trends in interest rates are one of the most significant factors influencing market
sentiment, as interest rates play a huge role affecting the supply and demand
of currencies.
Every currency in the world has interest rates attached to them, and these rates are
decided by central banks. For example, the Fed in the US determines the country’s
interest rates; the Bank of Japan (BOJ) sets Japan’s interest rates; the Reserve Bank
of New Zealand (RBNZ) decides on New Zealand’s interest rates and so on. Some
currencies have higher interest rates than others, and these are usually the
currencies that attract the most attention from savvy international investors who are
always looking across the global landscape in the continual search for a better
interest rate yield on fixed-income investments. This, of course, also depends on the
geopolitical or economic risks of that particular currency. Just like when a bank
lends money to a higher-risk borrower, high-risk currencies require a significantly
higher interest rate for investors to consider keeping money in those currencies.
What causes fluctuations in interest rates?
The value of money can and does decrease when there is an upward revision of
prices of most goods and services in a country. Generally, when a country’s
economy expands or when energy costs go up, goods ranging from clothing, food
to computers, and services ranging from public transport to spa treatments get more
expensive, thus eroding the value of money. The nice word for this erosion in value
is, of course, inflation.
Controlling inflation
Central banks are responsible for ensuring price stability in their own country, and
one of the ways they employ to fight inflationary pressures is through the setting of
interest rates. If inflation risks are seen to be edging upward in, say, the US, the Fed
would raise the federal funds rate, which is the rate at which banks charge each
other for overnight loans. When the overnight rate is changed, retail banks will
change their prime lending rates accordingly, hence affecting businesses and
individuals. An increase in interest rates is an attempt to make money more
expensive to borrow so that there will be a gradual decrease in demand for that
currency, thus slowing down an overheated economy. The opposite scenario is true
too: when a country faces deflation, or even decreased inflation, which is often the
result of decreased spending, whether by the government, consumers or investors,
it prompts the central bank to lower interest rates so as to stimulate spending.
Interest rates and currencies
The most important way in which interest rates can influence currency prices is
through the widespread practice of the carry trade.
A carry trade involves the borrowing and subsequent selling of a certain currency
with a relatively low interest rate, then using the funds to buy a currency which
gives a higher interest rate, in an attempt to gain the difference between these two
rates – which is known as the interest rate differential. The trader is paid interest
on the currency he or she is long in, and must pay interest on the currency he or she
is shorting. This difference is the cost of carry. Therefore, a currency with a higher
interest rate tends to be highly sought after by investors looking for a higher return
on their investments.
Rising interest rates in a country tends to strengthen that country’s currency relative
to other currencies as investors exchange other currencies to buy the currency of
that country when they transfer their assets into the country with the higher interest
rates. The increased demand for that particular currency will thus push up the
currency price against other currencies.
For instance, in 2005 there was a strong interest among Japanese investors to invest
in New Zealand dollar-denominated assets due to rising interest rates in New
Zealand. The then near-zero interest rates in Japan forced a lot of Japanese
investors to look outside of their country for better yields on cash deposits or fixedincome
instruments.
Economic growth
Besides interest rates, economic growth of countries can also have a big impact on
the overall currency market sentiment.
Since the United States has the largest economy in the world, the US economy is a
key factor in determining the overall market sentiment, especially of currency pairs
that have the USD component. A robust economic expansion, coupled with a
healthy labour market, tends to boost consumer spending in that country, and this
helps companies and businesses to flourish. A country with a strong economy is in
a better position to attract more overseas investments into the country, as investors
generally prefer to invest in a solid economy that is growing at a steady pace.
Investments pouring into a country requires the currency of that country to be
bought in exchange of other currencies; this increased demand for that country’s
currency should cause that currency to strengthen against other currencies. Forex
traders, expecting this consequence, will put on their bullish cap to buy that
currency before the investors do.
Some of the most important indicators of a country’s economic growth include:
1. Gross Domestic Product (GDP),
2. the unemployment rate, and
3. trade balance data.
These are explained below.
1. GDP
The GDPmeasures the total value of all goods and services that are originated from
the country; the GDP figure indicates the rate of the country’s expansion or
contraction based on output and growth. A healthy GDP figure usually adds bullish
sentiment to the currency of that country, especially if it exceeds the market’s
expectations.
2. Unemployment rate
The unemployment data reports the state of the labour market of a country. The
lower the unemployment rate, the more positive it is for the country’s economy, and
hence its currency, as consumers would feel more confident about spending if they
have jobs, and that would eventually impact on companies and businesses in the
country, generating more output.
3. Trade balance data
Another widely watched economic indicator is the trade balance data. Trade
balance measures the difference between the value of imports and exports of goods
and services of a country. If a country exports more than it imports, it has a trade
surplus. If imports exceed exports, then the country will end up with a trade deficit,
which does not bode well for that country’s currency because that currency has to
be sold to buy other foreign currencies in order to pay for those imported goods and
services.
For example, if the US imports an increased amount of goods and services from
Europe, US dollars will have to be sold in exchange to buy euros to pay for those
imports. The resulting outflow of US dollars from the United States could
potentially cause a depreciation of the US dollar against the euro or other
currencies, and that can affect market sentiment surrounding the USD. The
opposite scenario is true for a country that is experiencing a trade surplus. However,
market sentiment of a currency can still be bullish despite that country having a
trade deficit, as the net amount of trade deficit could be covered by an equivalent
or greater amount of capital investment pouring into that country, and thus would
not be a cause for concern.
Geopolitical risks
Geopolitical risk refers to the risk of a country’s foreign or domestic policy
affecting domestic social and political stability in another country or regional zone.
Global geopolitical uncertainties such as terrorism, transitional change of
government or nuclear threats can cause investors to lose faith in some particular
currencies, and they may prefer to shift their assets into a safe haven currency when
these circumstances arise. Market sentiment is very sensitive to such geopolitical
developments, and can cause a strong bias towards a particular currency.
For example, during periods of high tension in the Middle East in 2006, the market
formed a very bullish sentiment towards the US dollar, which became the preferred
currency to hold in such turbulent times, replacing the traditional status of the
Swiss franc as the safe haven currency. Forex traders should be keenly aware of the
current geopolitical environment in order to keep track of any potential change in
market sentiment, which could impact currency prices.
Source: 7 Winning Strategies for Trading Forex: Real and Actionable Techniques for Profiting from the Currency Markets
