In the same way that current and future earnings prospects are the most key factors to take into account when attempting to forecast the long term direction of a stock, current and future interest rates prospects are the most key factors to consider when attempting to forecast the long term direction of a currency. Due to this important factor, traders of all time frames need to understand currencies can be extremely sensitive to any economic news that may affect the country’s interest rates.
When the central bank of a country decides to raise interest rates this not only affects the short term rate that they target, but the interest rates for all types of debt instruments. If the central bank of a country raises interest rates then debt instruments of all types are going to become more attractive to investors, all else being equal. This means that not only are foreign investors more likely to invest in the debt of that country, but also that domestic investors are less likely to look outside the country for higher yield, thus creating more demand for the debt of that country and driving the value of the currency up.
On the other hand, when a central bank lowers interest rates, this causes the interest rates on all types of debt instruments for that country to be less attractive to investors. Therefore not only does this mean that both foreign and domestic investors are less likely to invest in the debt of that country, but it also means that they are also more likely to withdraw investment in order to obtain higher returns in other countries, which creates less demand for, as well as a greater market supply of that currency, and drives its value down.
The next important factor to understand is that foreign investors are affected by not only the potential profit or loss from interest rate changes on their debt instrument investments, but also to profits and losses that are a result of fluctuations in the value of that country’s currency. This is key due to the fact that while interest rate increases will generally result in higher profitability on investments, any increase in the value of the currency will be realized when the investment is sold and profits are exchanged back to their home country’s currency. This provides the foreign investor with that much more extra return on their investment, as well as more incentive to invest when interest rates rise, which pushes the currency value up.
On the other hand when interest rates fall, this has the effect of lower demand for the debt instruments of a country not only because of the lower yield to investors, but also because of the decrease in the value of the currency that generally comes along with a decrease in interest rates. The extra loss incurred by the foreign investor from the currency conversion which is a part of the investment, acts as an additional incentive to invest their money elsewhere, decreasing the value of the currency further.
As an example, let’s assume that you are a savvy investor operating out of the United States and you are looking to invest your savings somewhere where you can earn a decent return on your investment. For this particular slice of your portfolio you are looking for an interest paying instrument that will provide you with regular returns.
As you are most likely aware, a government or corporate bond will do just that paying you whatever the interest rate is as set by the country’s central bank that you are investing in, plus an additional interest rate depending on the length of the bond that you are investing in (for example a 1 year bond will generally pay a lower rate of interest than a 10 year bond) and for the extra risk that you are assuming for different bonds types (for example a government bond is normally going to pay less than a corporate bond because there is less chance that the government is going to default on the loan).
Therefore, with this in mind you decide to invest in a bond that pays a good rate of interest, and as you do not wish to be too speculative about your investment, you prefer a government bond over a corporate bond. The sake of simplicity let’s assume that the bonds of the countries that are available to you to invest in pay an interest rate equal to the interest rate in the country as set by the central bank.
Taking in this into account you would then examine what the different interest rates for the major countries of the world are and you make a list of these. Below are the rates that you come up with (bear in mind this is all for the sake of the example and these are not the current national interest rates):
After reviewing your list, it is clear that if you are making your decision based purely on interest rates, then New Zealand is the most attractive option as this will earn you an extra 6.25% in interest each year compared to investing that same money in the United States. It should be noted that New Zealand has been in a high interest rate environment relative to the United States for quite some time now. Therefore, bearing this in mind if you had followed this logic in the past then it would have worked out very well for you not only from an interest rate standpoint but also, as is shown in the below chart, from a currency appreciation standpoint. Because you would have been investing in New Zealand bonds you would have been holding New Zealand dollars and also benefiting from the large run up in the New Zealand Dollar.
Now while this has obviously been simplified in assist your understanding, this is not too far off from how international investors including large market moving hedge funds and other major players think. It is also a very good example of the forces we have discussed in our lessons on capital flows and in the last lesson on interest rates at play in today’s market.