Some economic announcements are known for their immediate impact on the currency markets. One of these announcements is interest rates.
Typically, countries with higher interest rates are more likely to attract foreign investors as they can expect a higher return on their investment than they could expect should they invest locally. As currencies are traded in pairs, this means that the currencies of countries with higher rates can often rise against those with lower rates.
So why do interest rates rise? If an economy is doing well, growth is rising and unemployment is going down, with consumers spending more of their money. This starts to boost inflation as the demand for goods increases. As the role of central banks is to maintain a certain rate of inflation, central bankers begin raising interest rates to reduce consumers’ disposable income, which in turn slows the rate of inflation.
Interest rates significantly contribute to the fundamental value of currencies – as stated above, higher rates attract foreign investment, and this increases external demand for the currency. At the same time, when central banks pump rates up it has the same impact as withdrawing funds from the economy, which further reduces supply and increases demand for the supply that remains. And, as in any market, higher demand and lower supply puts upward pressure on the price of that currency.
Central banks can also create a reverse scenario by lowering rates. If an economy is doing badly with stalling growth and rising unemployment, consumers are more conservative with their money. When the central banks lower interest rates, it is in the hope that consumers, who have extra cash now that their mortgage repayments aren’t so high, will start spending that extra money and give the economy a boost.
However, this also causes foreign interest in the currency to fall, because the return on their investment isn’t as high, which means that sellers start to outnumber buyers and the value of the currency starts to fall.
This makes rates and rate announcements an essential point of research for anyone interested in forex trading.
However, although these rules may hold up in ‘normal’ economic conditions, there are often exceptions, where a currency with a lower rate may outperform one with a higher rate. For instance, if an interest rate is rising due to concerns in the market about credit risk in an economy, then that currency is likely to fall, regardless of the central bank rate.
In Australia, the AUD has benefitted from relatively high interest rates since the global economic crisis. However, if rate cuts continue it could become more vulnerable.