How Are Exchange Rates and Interest Rates Connected?

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We are all aware of currency exchange rates. They are the ratios at which you can sell one currency and receive another in return. So, for example, if you’re traveling to France from the United States, you’d need to sell some of your dollars to buy euros which, at current exchange rates, you’d get approximately €92 for every $100 you exchanged.

If the dollar were to strengthen, Americans would be able to purchase more euros ahead of their trip, meaning they could either spend less overall or be able to buy more when shopping in Paris. Conversely, if the dollar were to weaken, US travelers would find themselves with less purchasing power.

Currency exchange rates affect your life far more than just how much spending money you can get when you travel abroad. They can change prices at home, influence your salary, and change the value of your investments. Additionally, in recent years, online trading platforms have made it much easier to begin forex trading in major, minor, and even exotic FX pairs since it can be done from just about anywhere with an internet connection. Therefore, understanding the factors that can influence an exchange rate has never been more important.

These factors are numerous. Trading volumes, the sentiment of traders, political events, the competitiveness of businesses, the values of third-party currencies, a country’s balance of payments, national debts, economic performance, and even intervention from a central bank or government can all weigh on a currency.

Another factor that plays a big role is interest rates. This is another economic term that most of us are familiar with because it can influence our daily lives, but did you know just how interconnected interest rates and exchange rates are?

The Correlation Between Interest Rates and Exchange Rates

Before we look at why these two elemental financial factors are connected, let’s first establish what their relationship looks like. As a general rule, if a country’s interest rate increases, its currency will appreciate against others.

It’s not possible to say that if the Bank of England increases its base rate by 50 basis points (0.5%), then the pound will strengthen by 0.5% against the dollar or euro. All of the other factors we discussed earlier will still contribute to overall determination, but we can accurately forecast the direction of travel.

The reverse is also true. If the Bank of England cuts the interest rate, then the pound will weaken against other currencies, though we can’t say by exactly how much.

Why Do Changing Interest Rates Affect the Currency Markets?

The prices of currencies fluctuate based on the desirability and necessity for someone to own that particular denomination. Interest rates change how desirable a currency is because they directly affect how much of a return someone can expect to receive from a bank in that country.

For example, if the Federal Reserve increases its Fed Funds Rate by 50 basis points, then savers can expect to receive 0.5% more interest from a bank. There are also bonds and other financial products that are connected to this rate, meaning the rate of return from these will also increase.

Therefore, a sufficiently wealthy German business or person could move money into the United States to take advantage of this increased return. In doing so, they’d have to buy the US dollar, thus, increasing demand for the currency while also reducing demand for the euro.

One transaction like this wouldn’t be enough to move the needle, but large capital flows from the eurozone to the USA would simultaneously increase the value of the dollar and force the euro to decline. 

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