How Interest Rates Affect Currency Exchange Rates

Interest rates and currency rates are inextricably linked in the global economy - interest rate changes made by a central bank will directly affect the movement of investors' funds across countries. The capital will massively influene the exchange rate of one currency to another.

The International Monetary Fund states that foreign investors typically pour their money into countries with high-interest rates, and as interest rates decrease investors will lose interest in that country's currency. This occurs because investors are always attempting to find higher yields for their capital.

Economists, investors, businesses and individuals involved with international commerce will benefit from understanding the connection between interest rates and exchange rates in order to grasp the causes of currency exchange rate fluctuations and leverage global financial patterns to better anticipate currency exchange rates.

What are Interest Rates and Currency Exchange Rates?

Interest rates are the cost of borrowing money and the interest paid on deposits, typically established by a central bank.

Exchange rates are constantly changing based on worldwide supply and demand. Central banks, such as the U.S. Federal Reserve and Reserve Bank of India, provide critical support in keeping interest rates stable, and the change in respective interest rates can have a secondary effect on the value of each currency.

How Does Interest Affect Money Flow?

When a country has a high interest rate, it has become more attractive to investment. Foreign investors will move their money into a country with higher interest rates to obtain better returns; therefore, they will be able to buy more of its currency.

The increase in demand for purchase of currency will cause its value will rise on the foreign exchange market. This will happen because there will be an increase in the number of people buying that currency, which will cause the value of the currency to appreciate in relation to other countries' currencies.

Even small variations in interest can cause a dramatic change in the value of a currency. Therefore, the market closely follows any decisions or policy announcements made by central banks.

Why do Higher Interest Rates Result in a Stronger Currency?

Due to higher interest rates, investors are drawn to countries with higher interest rates to invest because they are likely to receive a higher rate of return on their investments in bonds, savings or other types of financial instruments. Therefore, this increase in demand for the currency will lead to an appreciation in the value of the currency.

For example, if the European Central Bank decides to raise interest rates, the investors may choose to invest in Euro-denominated assets; therefore, the amount of Euro will increase and be used to purchase goods and services from Europe.

However, the magnitude of the positive impact of an appreciation of the currency will depend upon the level of confidence that the market has regarding the strength of the economy; therefore, if there is no confidence in the economy, then the appreciation of the currency will not occur.

Impact of Higher Interest Rates on Foreign Direct Investment

Higher interest rates encourage both short and long-term foreign investments; as a result, foreign investors will purchase government bonds, stock or deposits, which will increase the capital coming into the country. The influx of foreign capital helps spur demand for a country’s currency because investors have to convert their money to buy the local currency to invest.

Over the long term, investor confidence plays a large role in determining how interest rates can affect the value of the currency. If the economy is weak or there is political instability, the positive effect of interest rates will be diminished even if those interest rates are high.

Higher interest rates generally create the greatest value for a currency in stable and growing economies. Investors have a higher level of confidence in these countries compared to other country’s currency; therefore an increase in demand for investment in the local currency increases the value of the currency.

Effects of Lower Interest Rates

When interest rates are lowered, the value of the currency generally will be weakened due to a reduction of investment returns on the local currency due to the lower interest rate. When returns on currency are low, the investor will seek high-returning investment opportunities, thus creating capital outflow.

The amount of supply of the local currency for exchange decreases, thus reducing the value of the currency. Central banks, such as the Bank of England, will lower interest rates generally to stimulate economic growth by encouraging investing and spending by consumers.

In addition, when a currency is weak, relative to the currencies of the country’s international competitors, the weaker currency will appear to make goods cheaper and therefore provide a relative advantage for export sales. On the other hand, weakening a currency will also create a disadvantage for imports resulting in higher inflation.

Economic Trade-Offs from Low Interest Rates

• Increased Amount of Borrowing and Spending Assists in economic recovery
• Can create a boost to export activity due to weaker currency
• Can cause an increase in inflation due to higher costs of imported goods

Inflation, Interest Rates, and the Value of a Currency

The level of inflation has a huge effect on how interest rates are correlated with foreign exchange rates. If there is an increase in inflation, many central banks would choose to increase the interest rate to bring controlled inflation.

In the very short term, this could lead to foreign investors coming into the country, and therefore, drive up the value of the currency. Ultimately, however, if prices continue to rise above a certain level there would be little faith by investors in the economy's future and therefore, depreciation of the currency would occur.

The ECB closely looks at inflation levels before they make any decision regarding the interest rate. A central bank maintaining a balance between these two will ultimately maintain a strong currency over time.

Inflation versus Currency Value

A currency's depreciation will mainly occur as inflation rises, as an increase in inflation reduces the currency's purchasing power and as such; it reduces investors' appetite. Therefore, it is also likely that if there is high inflation, increasing interest rates won't provide any further incentive for investors to enter a country with a high inflationary economy.

Whereas the relatively low and stable levels of inflation signal a healthy economy, the relatively low and stable levels of interest rates will ultimately provide a level of confidence to global investors and would ultimately result in a stronger currency.

Central Banks' Involvement in Currency Movement

Central banks determine interest rates and set the policies that affect currency exchange rates. Institutions such as the Reserve Bank of India and the U.S. Federal Reserve regularly evaluate the economic conditions to establish whether to change the interest rate.

The global markets pay close attention to the decisions of central banks because the announcements tell them what direction the economy will move in the future. In fact, even the whispered or anticipated changes in policy can create immediate movement in a currency.

Market Response to Interest Rate Decisions

When central banks announce a rate hike, generally the currency will strengthen as the investors believe they will receive a higher return for their investments. Conversely, when a rate cut is announced, investors may want to invest elsewhere because the interest rate is now lower, and therefore, the currency will weaken.

The markets respond to the current interest rate decision; however, they also respond to the central bank’s guidance regarding its future decision.

Central Banks Require Credibility

Credibility is one of the most important factors for central banks to possess. When investors believe that the central bank of a nation has the ability to control inflation and provide economic stability, the investors will have confidence in the currency.

If investors perceive the central bank to be uncertain and inconsistent with its policies, then investors will withdraw their money from that currency, which in turn, will weaken the currency.

Global Factors Influencing Currency Values

The value of currencies can also be affected by interest rates and geopolitical events, trade balances, and trends in the worldwide economy. The World Bank stated that investors can quickly change their investment strategies when there are uncertainties globally.

Investors often move to more secure currencies, even if the interest rates in that country are lower, during periods of crisis. Therefore, changes in interest rates will always be affected by factors that the country has no influence over.

Effect of Global Market Sentiment

Depending on relevant global economic events or releases of statistical data, investor sentiment may change fairly rapidly. When the market is viewed in a positive light, investors generally invest in higher yielding currencies, while during periods of negative market sentiment, they tend to invest in less volatile investments.

Exchange Rate Effects Based on Trade Balance

The value of a currency, based on how many exports the country has and how many imports it receives, is influenced by trade balances. A country with a positive trade balance will generally have a stronger currency due to higher demand for the country's products.

Conversely, there will be less demand for a country's currency if there are more imports than exports, and its currency will have less value.

Real-World Examples of Currency Movements

Example One: Strength of the U.S. Dollar

When interest rates in the United States increase, the dollar is considered to be an excellent global currency, which has resulted in the U.S. dollar strengthening, as there is confidence in the underlying strength of the U.S. economy.

Example Two: Weakness of the Yen due to Low Interest Rates

Due to Japan’s long period of having a very low interest rate, the yen is no longer desirable for investors looking for a return. However, if there is a period of global uncertainty, the yen is still viewed as a safe-haven currency.

Conclusion

Interest rates are a major determining factor in exchange rates for currencies, and therefore, interest rates have an impact on money flows within the global marketplace. In general, as interest rates rise, investment increases and the value of that currency increases; while as interest rates decrease, the value of that currency decreases.

As stated earlier, although interest rates are a powerful influencing factor on the value of a currency, they are only one of many available factors that influence a currency’s value and the only way to fully understand how these factors will impact a currency’s value is to consider both domestic monetary policy factors and trends around the globe.