Impact Of Interest Rate News On The Forex Market
Similar to the prices of any product, forex rates are also determined by demand and supply factors. They move until an equilibrium price is found. News on interest rates has a significant impact on the demand and supply of currencies in the forex market.
Interest rates of countries whose currencies constitute pairs with other currencies drive forex rates by driving currency values and their mutual relationship. For example, in the USD/JPY (US Dollar/Japanese Yen) currency pair, the US Central Bank (the Federal Reserve Bank) cutting its interest rate or the Bank of Japan (Japan’s Central Bank) increasing its interest rate will lead to weakening of the US dollar with respect to the Japanese yen. The dollar’s value reduction will lead to the USD/JPY exchange rate falling, since one US dollar will now buy less Japanese yen. In a currency pair, the weakening of one currency will lead to an increase in the value of the other, so the Japanese yen will climb in value with respect to the US dollar.
A cut in the interest rate by a country also means that holders of that country’s currency will get less in terms of interest payments and will then experience a decrease in their willingness to keep their investment in the currency.
Yen Carry Trade refers to borrowing at low interest rates in Japanese yen and using the loan to buy assets and investments in other markets with the aim of accruing higher returns. For example, the 4.75 percent difference between interest rates of the U.S. and Japan is attributed to their respective rate of interests, which stand at 5 percent and 0.25 percent, respectively. Hedge funds invest in the currency pair by borrowing money in yen at 0.5 percent from Japanese banks and then exchanging the yen with US dollars by striking a forex deal with banks. With the U.S. currency, Hedge Funds invest in US bonds which will yield a minimum of 5.25 percent return on interest, earning a net of 4.75 percent from the investment strategy. The only potential risk to the strategy is the exchange rate of USD/JPY (US Dollar/Japanese Yen) as hedge funds will lose a lot of money if the exchange rate deviates from 5 percent.
Changes in the expectations of a country’s interest rates also affect the value of the country’s currency with respect to currencies that exist in pairs with it. For example, if economic data suggests that the Federal Reserve Bank of the US will increase interest rates, the currencies that pair with the US dollar will weaken accordingly.
Differences in the interest rates of two countries lead to capital flow between the two. The country with the lower rate of interest suffers capital outflow to the country with the higher interest rate, if they exist in a currency pair. For instance, in the example of Yen Carry Trade, lower interest rates in Japan will lead to capital outflow from Japan and inflows in terms of investments in US bonds.
