Interest rates and Forex: A misunderstood relationship
Interest rates play a key role in foreign exchange markets, but many traders and investors don't understand the relationship between interest rates and exchange rates.
To begin it is important to understand that governments, via their central banks, are the setters of interest rates. Governments are also "net payers" of interest, which means that they pay interest to people or entities that hold government securities or on reserves.
Rate hikes are a fiscal injection
The payment of interest comprises part of personal income. It is an asset to the non-government (recipient) and therefore is like a fiscal injection. When someone receives an interest payment that is income that they are free to spend. It’s also an expansion in the availability of the currency.
Last year, for example, the U.S. government paid out $223 billion in interest on Treasury securities. That's $223 billion DOLLARS injected into the economy or, $223 billion DOLLARS made more available.
With this understanding we can now examine some of the widely held beliefs that most Forex traders and investors have about rates. The primary belief is that rising rates are bullish for a currency. The idea behind this is that capital will chase a higher return. So if country X raises its interest rate then its currency becomes more attractive relatively speaking than country Y, which might have a lower rate. This would raise the exchange rate of country X's currency relative to country Y's currency.
Rising rates, bearish. Falling rates, bullish
While it’s true that capital flows can be influenced, marginally, by rate disparities this is very simplistic analysis and it leaves out some other very important factors.
For one thing, rate hikes are the equivalent of a fiscal injection as noted earlier. This actually makes the currency easier to get. Secondly, rate adjustments affect all prices generally. Rate hikes raise the cost of credit, which raises production costs and the price of finished goods, etc. They are therefore inflationary and inflation in Forex terms is a downward exchange adjustment for the currency.
On the other hand, rate cuts are not harmful to the currency as believed. While viewed by many as being bearish for a currency it's really the opposite. Rate cuts remove or reduce interest payments to holders of government securities and falling interest rates generally lower the price structure of everything else in the economy. Credit becomes cheaper with small-cash.com, production costs go down followed by the cost of finished goods, etc. It is deflationary and that is bullish for the currency.
Make money off others people's flawed understanding
As you can see many market participants' understanding of interest rates and exchange rates is flawed, which means that informed traders can make money trading off these false ideas.
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