The Influence of Interest Rates on Foreign Exchange Rates
In order to understand the effects of interest rates on foreign exchange rates, you should understand what a foreign exchange rate is. This rate specifies how much a currency is worth compared to another. It is always a comparison between 2 currencies, like EUR/USD or USD/AUD. Domestic interest rates can affect foreign exchange rates because interest rates directly affect the value of a country’s currency. Therefore, because foreign exchange rates are based on the value of currency, they will change depending on the domestic interest rates of that country.
Effects of Interest Rate Increase
In order to illustrate this, let’s use the example of U.S. dollars and Australian dollars. Let’s assume that interest rates in Australia are 5% and interest rates in the U.S. are 2%. Then, there is an increase in the U.S. interest rates by 0.25 points – making the U.S. interest rates 2.25% and the interest rates in Australia remain the same. This increase in the U.S. interest rate may influence some people to move their investments around in order to hold the U.S. dollar as they would be paid with a higher interest rate because of the change. Although the interest rates in the U.S. are fairly low in this example, the change in behavior of consumers can create more demand for the U.S. dollar and in turn, an increase in the foreign exchange rate between USD/AUD. Changing in the U.S. interest rate would not only increase the foreign exchange rates between USD/AUD, but all other exchange rates between the U.S. dollar and any foreign currency.
Effects of Interest Rate Decrease
Using the example above, let’s say that the opposite occurred and U.S. interest rates dropped by 0.25 points and the U.S. rates now were 1.75%. This could cause the demand for the U.S. dollar to decrease and investors ould move away from holding the U.S. dollar and put their investments into other currencies or assets. The drop in demand for the U.S. dollar would create a decrease in all foreign exchange rates between the U.S. dollar and all foreign currencies. In summary, with all else held constant, a domestic interest rate increase will cause an increase in demand for that currency and the foreign exchange rates of that currency compared to all other foreign currencies will increase. Conversely, a domestic interest rate decrease will cause a decrease in demand for that currency and the foreign exchange rates of that currency compared to all other foreign currencies will decrease.Note: Past performance is not an indication of future results. This post is not investment advice. CFD trading bears risk to your capital.