Last updated on March 24th, 2023 at 04:58 pm
How do interest rates affect exchange rates? In short, the higher the interest rate of a currency, the more likely it is to strengthen. Let’s explore why below.
Higher Interest Rates Attract Foreign Capital
When a country’s interest rates are higher compared to other countries, it tends to attract foreign capital. Investors seek higher returns on their investments, so they may move their funds to the country offering higher interest rates, thereby increasing demand for the local currency and causing it to appreciate.
Higher Interest Rates Attract Speculators
When investors expect a currency to appreciate due to higher interest rates, they may engage in speculative trading, further driving up the demand for that currency and causing it to appreciate.
Central Bank Interventions
Central banks occasionally intervene in the foreign exchange market to manage their currencies. For instance, the Swiss National Bank famously intervened in 2011 to halt the rapid appreciation of the Swiss franc, which was causing economic difficulties for the country. Central bank interventions like these can directly influence exchange rates, further highlighting the connection between interest rates and exchange rates.
Examples of interest rates affecting currency pairs
In 2022 the US Dollar strengthened more than 20% against the Japanese Yen because of the high interest rate of the US Dollar and low interest rate of the Japanese Yen.
The US Dollar yielded an interest rate of 1.75% in June 2022, while the Japanese Yen yielded -0.1%.
This difference widened further in September 2022, with the US Dollar’s interest rate increasing to 3.25% while the Japanese Yen continued to yield -0.1%.
Australian Dollar appreciation against Yen in 2003-2007
During 2003-2007, the Australian Dollar strengthened more than 50% against the Japanese Yen because of the large interest rate differentials between both currency pairs.
At its peak, the Australian dollar was paying 7% interest versus the Japanese Yen’s 0.5% interest.
How to trade forex using interest rate information?
Buy currencies with increasing interest rates or high interest rates while selling currencies with low interest rates or decreasing interest rates. A list of current interest rates.