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How do interest rates affect the Forex market?

How do interest rates affect the Forex market?
Asked by
Jane Goodwin categorie-icon time-icon10 months ago
1 Answer Answer Question

Justin Freeman
Answered time-icon10 months ago

Generally speaking, if everything else is equal, higher interest rates in a country will translate to a stronger currency relative to currencies where the country’s interest rate is lower. Of course such a simple relationship isn’t the case when we’re dealing with the real world, where there may be hundreds of influences on the value of a country’s currency.

So, interest rates are a major factor influencing the value of currencies, but there are many other elements that help determine the movements of currencies in relation to one another in the forex markets.

Theoretically higher interest rates will boost the value of a currency. That’s because higher interest rates help attract foreign investment, which increases the demand for the country’s currency. And on the other side of that coin lower interest rates deter foreign investment and decrease the value of a currency.

The seemingly simple relationship between interest rates and forex markets is complicated by a host of other factors. One of the clearest primary factors is the relationship between interest rates and inflation. Higher inflation has the tendency to put downward pressure on a currency, so if a country can successfully increase interest rates without increasing the inflation rate there is a better chance the value of that country’s currency will rise.

In addition to the relationship with interest rates, currency values are also heavily impacted by political and economic stability, as well as trade demands. In fact, these factors often have a greater influence on forex markets than interest rates at any given time. A country’s GDP or trade balance can be critical to the value of that country’s currency. This is true because greater demand for a country’s products means there will be a corresponding increased demand for that country’s currency to purchase said goods.

Another potential factor in valuing currencies is the amount of debt a country holds. High levels of debt can lead to higher inflation, which we already know is a drag on the value of a country’s currency.

The Turkish Lira in 2018 has been a good example of how all these factors can influence the value of a currency. Due to extremely high levels of debt and inflation running near 16% the Lira lost nearly 50% against the U.S. dollar in the first half of 2018.

By late July there were increasing fears of an economic slowdown in Turkey, and a geopolitical situation was brewing between the U.S. and Turkey over the extradition of a U.S. pastor. The first week of August saw the Lira fall another 25% against the U.S. dollar to its lowest level ever. By the end of August Turkey had raised interest rates to an astounding 24% in a bid to lower inflation.

In fact it had the opposite effect and by October 2018 inflation in Turkey was running above 25%. While we might expect that to keep the Lira weak, in fact it has been strengthening against the U.S. dollar in the previous two months as traders ignored the inflation effect, focusing instead on the increased political stability in Turkey.

Therefore, higher interest rates don’t always lead to a stronger currency, and rising inflation doesn’t always lead to a weaker currency. Instead, traders must weigh dozens of inter-related factors to predict whether a currency will rise of fall in price.

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