Currency Interest Rates, Capital Flows, the Central Banks. The way they impact the currency market

If there is one overriding influencing factor in the currency market, it is interest rates. The Central Bank of a country or economic group sets the interest rate on their currency.  They adjust these rates in an effort to encourage trade and maintain control over inflation.  Lower interest rates will encourage economic expansion, as credit becomes cheaper.  Higher interest rates will retard economic expansion as the “cost of money” becomes more expensive.  Changes in interest rates can also greatly affect the value of a currency, which we shall talk of in more detail later.

Following the interest rate decisions for the Federal Reserve’s Open Market Committee (FOMC), which sets the overnight Fed Funds Rate, is extremely important when trading the U.S. Dollar. When the Fed raises interest rates, the yield offered by dollar-denominated assets are higher.  This generally attracts more traders and investors.  If interest rates are lowered, that means that the yields offered by dollar-denominated assets are less, which will give investors less of an incentive to invest in dollars.  Yet it is not just the rate itself that is important.  What is also very critical for FOMC decisions is the language in the statement that accompanies the FOMC’s decision.  Actually, oftentimes by the time of the decision announcement, the decision has already been factored into the market; only slight fluctuations are seen if the decision was the decision that was expected.  The accompanying statement, on the other hand, is analyzed word-for-word for any signs of what the Fed may do at the next meeting. Remember, the interest rate decision itself tends to be less important than the expectations for future interest rate moves.
                                 

Each currency carries with it an interest rate.  This is almost like a barometer of that economy’s strength or weakness.  As a nation’s economy strengthens over time, prices tend to rise as the consumers are able to spend more of their income.  The more we make, the better our vacations can be, and the greater amount of goods and services we are able to consume.  In other words, more dollars are chasing roughly the same amount of goods and this leads to higher prices for those goods.  The rise in prices is called inflation, and Central Banks watch this very closely.  If inflation is allowed to run rampant, our money will lose much of its buying power, and ordinary items such as a loaf of bread may one day rise to unbelievably high prices such as a hundred dollars per loaf.  It sounds like an unlikely far-fetched scenario but this is exactly what occurs in nations with very high inflation rates, such as Zimbabwe.  To stop this danger before it emerges the Central Bank steps in and raises interest rates in order to stem inflationary pressures before they get out of control.  Inflation is very difficult to stop once it begins, hence the Fed’s constant, almost paranoid vigilance in the fight against it.  Higher interest rates make borrowed money more expensive, which in turn dissuades consumers from buying new homes, using credit cards, and taking on any additional debts.  More expensive money also discourages corporations from expansion, as so much business is done on credit, from which interest is always charged.  Eventually, higher rates will take their toll as economies slow down, until a point where the Central Bank will once again begin to lower interest rates, this time to encourage economic growth and expansion -- and so the cycle continues.  Trying to foster growth while at the same time keeping inflation low is the delicate tight rope that the Fed walks during each FOMC meeting.  Other Central Banks also do the same at their regular meetings.

Below is a table of the interest rates on the major currencies as of this writing in October, 2009.

By increasing interest rates, a nation can also increase the desire of foreign investors to invest in that country.  The logic is identical to that behind any investment: The investor seeks the highest returns possible.  By increasing interest rates, the returns available to those who invest in that country increase.  Consequently, there is an increased demand for that currency as investors invest where the interest rates are higher.  Countries that offer the highest return on investment through high interest rates, economic growth, and growth in domestic financial markets tend to attract the most foreign capital.  If a country's stock market is doing well, and they offer a high interest rate, foreign investors are likely to send capital to that country.  This increases the demand for the country’s currency, and causes the currency’s value to rise.

Money will always follow yield.  Should a country increase its interest rate, we will see the general international interest in that currency increase as well.  Recently, the Reserve Bank of Australia (RBA) raised the interest rate on the Aussie Dollar 25 basis points to 3.25%.  The AUD was already strong against other currencies and this move will only serve to strengthen it further.  As a result, pairs such as the AUD/USD, AUD/JPY, GBP/AUD have reflected that strength.  Conversely, should the Central Bank of a country lower the interest rate, we will see capital flow away from that particular currency.

Some of the characteristics of Central Banks are:

• They have access to huge capital reserves.

• They have specific economic goals.

• They regulate money supply and interest rates.

• They set the overnight lending rates to change the rate of interest paid on their domestic currency.

• They buy and sell government securities to increase or reduce the supply of money.

• They sometimes buy and sell their domestic currency in the open market to influence exchange rates.

Clearly interest rates and their changes can have strong impact on the capital flow that a country experiences.

Let me give you a quick overview of the concept of Capital Flows and some of the differences between a positive and negative capital flow.

As we discussed in the last lesson, capital flows represent money sent from overseas in order to invest in a country’s markets.  They can greatly affect a nation's currency price, as a positive capital flow shows demand for investments in that nation's currency, while a negative capital flow would show weak demand compared to supply.

As you might suspect based on the significance of this topic, mere discussions by Central Banks of potential changes in interest rates are followed very closely and can themselves impact how related currency pairs move.  Clearly any announcement of an actual interest rate change are met with rapt attention on the international economic stage and can be potentially trend-changing events for currencies.

The main Central Banks involved in this process are the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve (US), Swiss National Bank, the Reserve Bank of Australia and the Reserve Bank of New Zealand.

The individual banks meet on a regular basis, generally on a 4 to 6 week cycle, depending on the bank in question.

The specific dates of these meetings, along with other fundamental announcements that impact the currency market, can be tracked on Daily FX’s Global Economic Calendar.  This calendar can be accessed at http://test.dailyfx.com/calendar/.

Source: http://www.dailyfx.com/