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Interest Rates: the King of Currency Flows

There are many factors influencing the value of one currency in relationship to another: political stability, economic growth rates, savings and capital formation, natural resources and a government that encourages the development of these resources, the success of the education system, demographic trends, the imagination, initiative and creativity of the population are merely a few of the determinates of the wealth of a country. Does the population of a country have the freedom to pursue dreams? Is a successful entrepreneur allowed to keep the fruits of his financial success, or is he shamed into feeling guilty because of his success, and punished by punitive taxation. These are all factors in determining the wealth and prosperity of a country and the value of it’s currency, but the most important factor in forecasting the direction of a currency is always INTEREST RATES.

When attempting to determine the value of a currency, you must remember that the value is determined by the relationship to something else--a product or a commodity such as gold or the value as stated in terms of another currency. Part of the calculation of a currency's value in relation to another currency is the difference in interest rates between the two countries. In an imprecise way, interest rates reflect the rental costs of money. If you have a shortage of money and want to buy a car, or need money to meet current expenses, you will have to borrow money, and pay interest to the lender.  Should you be blessed with a surplus of money, you may be able to lend your money and collect interest. 

  Interest Rate Rule of ThumbHigher interest rates usually lead to a higher currency value while lower interest rates usually lead to a lower currency value. When the interest rates are rising in one country, investors from around the world will buy that country's currency to invest in the bond market to lock in those higher interest rates.This flow of money has a great influence on the value of that country's currency as the buying interest pushes up the value of that currency.

The interest rates below show the current minimum government short term rates, as of January 2010. The rates are interesting; telling us, in part, why the market is where it is, and may provide short term guidance as to where a country's economy might be headed. For example in the table below, the extremely low rate in Japan implies that their central bankers do not anticipate a quick or strong economic recovery. The strong Australian rate means that the recovery of business activity is taking place and the central bank does not want the speculative enthusiasm to create a speculative bubble.

Country Current
Interest Rate
Previous Last Change
0.5% 1.0% Mar 05, 2009
4.5% 4.25% May 05, 2010
0.25% 1.0% Dec 16, 2008
0.0% 0.1% Oct 05, 2009
1.0% 1.25% May 07, 2009
0.25% 0.50% Mar 12, 2009
1.0% 0.75% Sep 08, 2010
3.0% 2.75% July 28, 2010

Climbing Interest Down Under To illustrate how markets react to changing interest rates, lets look at the Australian Dollar. During most of 2009, the Australian economy recovered quicker than others in the developed world. The Chinese recovery and their demand for Australian raw materials proved to be a boom for the Aussies, and their economy grew. Responding to this growth, the Central Bankers in Australia decided they would raise the interest rates gradually. Higher rates would attract capital for the development of an expanding economy and provide a possible brake on the economy should inflation start to surface.
Higher interest rates resulted in a higher currency. The AUD climbed from the low 60’s to a high of 94.05 in mid November. As the economy grew, the Central Bank gradually raised the rates and the currency went up. The Central Bankers were optimistic and hinted of higher future rates. (Optimistic central bankers are called hawks, and pessimistic bankers are called doves.) Investors in Japan borrowed money there, at cheap rates, to invest in Australia and made money two ways. The Australians paid them more interest on their capital and the AUD appreciated versus the yen.

Then, in November, the Australian bull move came to a halt, not because the economy was slowing down, but because the Central Bankers hinted that future rate increases would be deferred or postponed entirely, depending on the level of economic activity.This caused the market to retreat, selling off almost 700 points. 

Markets look ahead and attempt to foresee the future. Yes, the current interest rate is important, but this is old information that the market has already digested. Anticipation of where future rates are headed is of much more interest to market participants. The past is over and done, but the future is a mystery, and perhaps an opportunity.

Interest Rates and Rollover

Interest rates also determine the amount of rollover credited or debited to one's account at the 5PM Eastern close. Rollover is the interest paid or earned for holding an FX position overnight. As we now know, each currency has an interest rate associated with it, and because FX is traded in pairs, every trade involves not only two different currencies, but their two different interest rates. If the interest rate on the currency you bought is higher than the interest rate of the currency you sold, then you will earn rollover (positive roll). If the interest rate on the currency you bought is lower than the interest rate on the currency you sold, then you will pay rollover (negative roll). Rollover can add a significant extra cost or profit to your trade. Traders who look to take advantage of this rollover interest are referred to as carry traders. These carry traders also have a big influence on the value of currencies as those pairs that pay the most in interest generate the most buying interest which in turn, pushes the value of those currencies with higher interest rates even higher.

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