The relationship between exchange rates and interest rates

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Movements in exchange rates and interest rates are closely linked.Movements in these rates have a direct impact on the currency value relative to other currencies. This also has an impact on traders and investors.

The impact of interest rate increases on exchange rates

Interest rate hikes increases the rate of return on assets denominated in the respective currency.This has the effect of attracting more investors.
An increase in rates also helps to combat excessive inflation. Inflation causes a currency to lose value in the foreign exchange market.

An increase in interest rates therefore has a positive impact on the value of a currency. For example, if interest rates in the United States rise, the dollar will, theoretically, appreciate against other currencies. EUR/USD exchange rate should therefore fall.

The impact of interest rate decreases on exchange rates

Decreases in interest rates reduces the return on assets denominated in that currency and encourages inflation. The value of the currency concerned will therefore depreciate against other currencies. For example, if the US lowers its interest rate, this theoretically causes EUR/USD exchange rate to rise.

The difference between theory and practice

Of course, all this is only theoretical. In fact, a rise or fall in interest rates can have the opposite effect on exchange rates.When reading economic data, the trend of the indicator is far more significant than the figure itself.Consensus must also be considered.While most investors anticipate that interest rates will go up/down, exchange rates already incorporate the announced movement before it is made.The biggest movements in exchange rates usually occur when announcements are counterproductive to consensus.

The impact for traders

Movements in the return on assets denominated in a currency have an immediate effect on all traders.In fact, every evening, at the close of the day on the forex market, your broker carries out a Swap transaction.You receive the interest rate for the currencies you have purchased and pay the interest rate on the currencies you have sold. The swap transaction relates to the interest rate differential between two currencies.

Let's say you have a long position in EUR/USD.Interest rates are as follows: 1% for the Euro and 2% for the Dollar.In this case, you receive 1% and pay 2% interest on your position. The rate differential is against you and so you will pay to keep your position the next day.

The impact for investors

The movement in the interest rate differential between 2 currencies can lead to carry trade operations. Carry trades can create long-term trends in exchange rates.Traders buy currencies with high interest rates and sell currencies with the lowest interest rates.As a result, foreign exchange swaps are to their advantage and in some cases they can also benefit from the favourable trend of the exchange rate.

If you invest in foreign equities or bonds, it is therefore very important to take into account the movement in the exchange rate between your currency and your assets’ currency.If exchange rate fluctuations are unfavourable, this may partially or completely cancel out your capital gain or even make your investment lose.

Let’s take an example. You buy Japanese shares and make a 15% capital gain.If at the same time the EUR/JPY has dropped 15%, your operating balance is zero. Effectively, your capital gain is denominated in Yen and you have to convert it to Euro.

To continue reading, you can consult:
- Interest rate parity theory

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