How does the interest rate affect exchange rates?

Fundamental analysis highlights the various factors that influence the exchange rate. At the same time, the degree of their significance for the justification of market fluctuations varies. Thus, at the end of the last century, investors closely monitored indicators of money supply and budget deficit, in the first half of this century they gave way to the state of the trade balance and the dynamics of interest rates, at present the attention of the world community is focused on the external debt and the volume of public lending.

Nevertheless, it should be taken into account that all fundamental factors are closely related to each other and in order to predict the dynamics of exchange rates in the medium or long term it is necessary to understand this relationship. This can be helped by interest rate differential.

It represents the difference between the main interest rates of central banks, which are an important tool of monetary policy. For example, if the European Central Bank changes the refinancing rate, it directly affects the size of interest rates on loans, deposits and other money market instruments.

Impact of the interest rate

In order to understand the mechanism of the impact of such a decision of the regulator on the exchange rate in normal conditions, we can draw parallels with real life. If we have savings placed in one commercial bank, and another bank nearby increases the interest rate on the attracted deposits, and it becomes higher than the rate at which we opened a deposit, it makes sense to close it and move to a neighboring bank for service. It is assumed that the degree of reliability of the banks under consideration is the same.

International investors - are the same people, so if under normal conditions one of the Central Banks raises the interest rate, increasing the profitability of money market instruments, they begin to provoke capital flow from the economy of one country to the economy of another. But in order to buy more profitable assets, you need to buy the national currency.

Thus, an increase in the interest rate differential, all other things being equal, leads to an increase in the exchange rate of the country. The phrase "other things being equal" means that the main macroeconomic indicators of the two economies under analysis are comparable. First of all, the levels of inflation and unemployment. After all, it is known, for example, that in many developing countries a significant increase in the consumer price index causes the need to raise the refinancing rate. And this will not mean that foreign investors will be more interested in investing in the economy of such country. All the same, "banks should have the same degree of reliability.

Nevertheless, even in countries with comparable levels of development an increase in the differential of interest rates does not always lead to an increase in the exchange rate of the national currency. For example, during the development of the economic crisis, a decrease in the differential can lead to an increase in the rate. The reason for this is the desire of investors in this period of the economic cycle not to multiply, but to preserve their own capital. Decrease of "appetite for risk" contributes to growth of demand for low-yielding currencies, characterized by low interest rates of central banks. After all, the lower the yield, the lower the risk.

We could see a similar situation in 2008, when the development of the mortgage crisis forced investors to seek "safe harbors" in the form of treasuries bonds The euro has fallen sharply as a result of the rise in demand for the dollar. As a result, the demand for the dollar increased, and the euro fell sharply.

Thus, in order to understand the mechanism of the impact of the interest rate differential on the exchange rate it is necessary to understand at what stage of the economic cycle the world economy is at. So in During a recession and recession, a decrease in interest rates can lead to an increase in the exchange rate of the national currencyand, on the contrary, in the conditions of recovery and growth, an increase in the differential will contribute to an increase in its quotations.

Looking deeper, we can understand the close relationship between central bank interest rates and key macroeconomic indicators. For example, a recent speech by the chairman of the U.S. Federal Reserve addressed the need to keep key interest rates low through 2014.

Republicans criticized the Fed for this decision, which encourages inflation.

The dynamics of the U.S. consumer price index,%

Really low interest rates on loans are good for consumers, who increase demand for goods and thus stimulate price increases.

But Ben Bernanke was relentless: the current Federal Funds rates are necessary for an economy rising from its knees: cheap credit is much more important for American businesses that need to increase production. And this requires not only "cheap money," but also labor. So monetary policy can have a favorable effect on the labor market, which is still a worrying state of affairs. Moreover, low interest rates reduce the cost of servicing public debt, which in the United States reaches 93-94% of GDP.

Thus, the interest rate differential is closely related to such macroeconomic indicators as inflationunemployment, industrial production, and many others.

How to use such knowledge for an ordinary investor?

The fact is that based on the dynamics of fundamental factors, it is possible to determine the further activities of central banks, carried out in order to stimulate the economy.

The upper figure shows the dynamics of the euro/dollar currency pair, while the lower one shows the difference between the interest rates of the European Central Bank and the Fed. As can be seen from the graphs, there is a fairly close relationship between them.

Based on the fact that the Federal Reserve plans to leave the key interest rate alone until 2014, further movement of the euro/dollar currency pair will directly depend on the measures taken by the European Central Bank. And if the issued and planned three-year loans are not enough to stimulate the economy, the regulator will be forced to cut the refinancing rate. I would not be uninterested in readers' opinions on the question "what is the risk?" and "how might this affect the exchange rate?".

Of course, it is not reasonable to make forecasts based on the interest rate differential alone, so in my further materials we will continue to study the fundamental factors affecting the exchange rate.