The Impact Of Interest Rates On Currency Rates

Lowering and raising interest rates affects the currency rates on the foreign exchange market immediately and serves as an instrument influencing the value of particular currencies.

Many fundamental factors determine the supply and demand for a particular currency and its value against other currencies. Among these factors are interest rates. Central banks are the institutions that set the base rates in a country and change their levels to streamline the development of the local economy. Increasing the interest rate will result will in raising value of the nations currency while lowering interest rates should have the opposite effect, respectively.

In general, interest rates initially affect various government bonds, especially bond yields, creating demand for the currency in which these bonds are denominated, resulting in appreciation of the local currency. The economic theory presupposes such behaviour of the market participants although they often behave in a different manner and under the influence of other factors. Sometimes, investor will look for a safe haven regardless of the fact that interest rates are high in their country, because they do not believe in the local economy or consider the currency rates as unfavourable in the long-term.

Interest rates influence also the entire economy; determining the cost of lending and borrowing money, creating lower or higher money supply and demand, respectively. A factor you should consider when the matter in hand is high nominal interest rates is the level of inflation. A high inflation rate can offset against the high interest rate.

An interesting phenomenon relative to interest rates is that very often the foreign exchange market is driven by perceptions and forecasts of future interest instead of the actual levels set by the central banks. Therefore, when Forex dealers en masse believe that interest rates in a particular country might fall, they could start selling the nations currency regardless of the fact that all fundamental indicators are sending positive signals.

All these factors are important but only in the situation of a free-floating currency and open economy i.e. no excessive trade and investment restrictions and lack of restrictive foreign exchange regulations. If these conditions exist, the currency rate will be influenced by changing interest rates and will appreciate and depreciate accordingly. On the other hand, the countries offering highest yields on their bonds are not very predictable ones and their bonds usually bear higher risk for investors. Hence, the very first alarming signal relative to this country will urge the investors to divest their investment and the currency value will fall immediately, resulting in less advantageous currency rates against the major world currencies.

Taking decisions to cut or increase the base rates is a complicated process involving many high ranking officials. The central banks actions are scrutinised by other governments and market players because interest rate changes influence the exchange rate directly and indirectly. As a rule, the market reacts promptly to correct the actual currency rate of the respective currency. Nevertheless, the market as a whole will respond unexpectedly on many occasions since the Forex market is very hard to predict. Nobody can push the currency rates lower or higher if the market mood urges investors to head in the opposite direction.