Although there are lots of factors that determine the value of a currency, the interest rate of a country is one of the most significant factors that determine the currency value. Forex traders, in reality need to concentrate on the interest rates of the currency they are trading more than anything else. This article discusses the meaning of interest rates and the impact it has on the currency value of a country.
Signs to search for
If there is a comparatively stable geopolitical and economic condition globally, the forex market commonly favors a currency with high interest rate and currencies that their interest rates are expected to rise in the near future. Apart from that, interest rates are just one among the many factors that affect the currency value. The rest factors are war, geopolitical concerns, inflation, how the currency correlates to other markets, and a few more factors.
Higher interest rates commonly result to influx of foreign investment in a country. The reason why this occurs is that money constantly flows to “where it gets the best treatment.” For instance, if you operate a gigantic hedge fund, your anticipation would be to get higher profits for your subscribers. If one country spends five percent to get a bond and another country spends two percent to obtain similar form of bond, in that case, the first country is more favorable to invest in.
To be able to purchase that bond, or invest in that financial medium, you would be required to acquire the bond in the country that owns the bonds. A few countries will pull out bonds and other currency like the US dollar.
A simple sample scenario to illustrate this
If you want to invest some money you have in the United Kingdom elsewhere. Naturally, you would like to invest your money where you would make the largest profit. Basically, central banks will increase interest rates of their country if the economy of their country is booming. This has to do with some form of timing. However, you may choose to invest the money in the stock market, whereby you would be required to buy stock in a local currency. Why the interest rates are commonly raised is that they are afraid that there would get to a point where the country’s economy would boil over.
All the same, it is possible that stocks price rises in such scenario. After checking through the global economy, you could feel that France is the right place for you to invest the money given the fact that a lot of multinationals from France have witnessed a lot of export growth. To be able to purchase stocks on the DAX, you’d be required to purchase the euros.
In a case like this, you’ll definitely need to purchase the EUR/GBP pair. If the economy of the European Union is strong, you’d probably want to purchase both stocks and bonds in euros. Thus, money naturally flows to the place that it expects to make the highest return. It could be that the interest rates in the UK are 1.00 percent, while the interest rates in EU are 2.25 percent, for instance.
It could happen that some months afterwards, the global financial situation changes greatly. The world is about to face a global recession. In this case, you’ll be required to safeguard the value of your money. A situation like this was experienced during the last financial crisis, and the forex market started to behave in a manner that majority of people viewed would not be shrewd. When the there was outburst of the US housing bubble, other currencies originally increased in value. Nevertheless, the US dollar began to quickly gain momentum after awhile having faced some upset initially.
During that time, many countries around the globe moved their money into the US treasury market and this escalated the value of the dollar. However, this was not a wise decision given the fact that the interest rates were reduced fast where the reality that led to that decision is that countries wanted to keep their funds secure.