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Talking Points

  • Future interest rate expectations take precedence over the headline rate
  • If a country has a high interest rate, but no further increases are expected, the currency can still fall.
  • If a country has a low interest rate but is expected to raise interest rates over time, its currency can still rise

While it is easy for Forex traders to understand the logic of why investors move money from lower yielding currencies and assets to higher yielding assets and currencies. They may also believe that the simple mechanism of supply and demand is responsible for currency movement. However, this is only part of the story. The expectation of future interest rate increases or rate cuts is even more important than just the actual rates themselves.

Learn Forex: Rate Expectations Sinking GBPUSD

Interest Rate Expectations: The Driver of Forex Rates

Created by Gregory McLeod

For example, the United Kingdom had interest rates that hovered between 4.5 and 4.75% which was much higher than the 3.25% in the United States. Conventional wisdom would dictate that GBPUSD should have went up during this time period. However, as seen in the chart above, this was clearly not the case as GBPUSD headed lower. The reason for this was the expectations that the US Federal Reserve would begin a rate tightening cycle. The 250 basis point premium enjoyed in the UK at the beginning of 2005 narrowed to just 25 basis point difference. The Fed raised the interest rate from 3.25% in December 2004 to 6.00% by May of 2006.

If a central bank decides to one day, hike rates and then say that they are through raising rates for the foreseeable future, then a currency can still sell off though the interest rate was raised.

On the other hand, if a central bank begins to aggressively raise interest rates to curb inflation and inflation remains stubbornly high, investors around the world realize that there is nowhere for rates to go but up. The currency of that nation may continue to rise as expectations for more rate hikes become widely anticipated.

Learn Forex: NZD/USD Uptrend with Interest Rate Increases

Interest Rate Expectations: The Driver of Forex Rates

(Created by Gregory McLeod)

In the example above, NZDUSD rose 57% as the Reserve Bank of New Zealand continued to raise rates. From 2002 to 2005 the RBNZ raise interest rates from 4.75% to 7.25% while the Fed increased rates from 1.73% to 4.16% over the same period. Investors in search of higher yields trade the low yielding dollar for the higher yielding NZD. The result was NZDUSD rallying 57%.

If the chances that interest rates can be raised in the future is near zero, investors will want to look elsewhere for a country whose rates are rising. The market is a discounting mechanism which means favorable news, like interest rate hikes are already built into the price. To continue to offer value, there must be an indication that rates will continue to rise to justify the inflated price in the currency. Without any expectations of a rate rise, there is little incentive for new investors to enter or for past investors to remain.

On the other hand, extreme levels of interest rates can shift and move interest rate expectations in the opposite direction because investors believe that interest rates may revert back to the mean. Much like a rubber band stretching to extremes and snaps back, interest rates behave in a similar manner. The extreme interest rates of the 1980’s in the U.S. that topped out at 20% saw a snap back toward 3% in the 1990’s. The extreme low interest rates around the world following the Global Financial Crisis of 2008 may revert back to the mean which is much higher than current 3%. The bottom line is that Forex traders have to not only watch the headline currency rate, but they also have to monitor interest rate expectations in order to keep themselves on the right side of the trade.

Next: How a Currency Can Change the World (16 of 63)

Previous: Interest Rates and the FX Market

---Written by Gregory McLeod Trading Instructor