How do interest rates affect exchange rate fluctuations?

2023-06-20
Summary:

There is a close internal connection between the interest rate market and the foreign exchange market, and a country's interest rate level directly affects the exchange rate level of its own currency.

There is a close internal connection between the interest rate market and the foreign exchange market, and a country's interest rate level directly affects the exchange rate level of its own currency. This article will delve into how interest rates affect exchange rate fluctuations.

exchange rate fluctuations

The official interest rate level of a country is controlled by its currency management authority, and changes in one country's interest rate relative to another country's interest rate can cause fluctuations in the exchange rate.


Most transactions in the foreign exchange market are spot transactions, also known as spot foreign exchange trading, which refers to a trading behavior where both parties handle delivery procedures on the same day or within two trading days after the foreign exchange transaction is completed. Spot foreign exchange trading is the most commonly used trading method in the foreign exchange market, accounting for the majority of total foreign exchange transactions. This is mainly because spot foreign exchange trading can not only meet the buyer's temporary payment needs but also help the buyer and seller adjust the currency proportion of foreign exchange positions to avoid foreign exchange risk.


Forward foreign exchange trading, also known as futures trading, refers to forward foreign exchange trading where the delivery date is two business days after the transaction. In forward foreign exchange transactions, foreign exchange quotations are more complex. Because the forward exchange rate is not a realized exchange rate that has already been delivered or is currently being delivered, it is a prediction of future exchange rate changes based on the spot exchange rate. Forward exchange rates include two factors: spot exchange rates and future expectations. When the forward exchange rate of a currency in the foreign exchange market is higher than the spot exchange rate, it is called a premium; when the forward exchange rate of a currency in the foreign exchange market is lower than the spot exchange rate, it is called a discount.


Spread arbitrage

The foreign exchange market is composed of two factors: "buy" and "sell", both of which are indispensable. When you buy and sell currency pairs in the foreign exchange market, it means that you are both buying and selling a certain currency.


In theory, if you engage in cash and foreign exchange trading, you can directly deposit it in the bank to generate interest. It's equivalent to lending money to a bank, which needs to pay you interest at a certain rate. The amount of interest you receive depends on how long you have deposited the money in the bank. The longer the time, the higher the interest rate, and the more interest.


In the long run, the volatility of the foreign exchange market is closely related to the changes in interest rates between the two countries, and the currencies of countries with higher interest rates are often more attractive. But there is no free lunch in the world. You can really use the difference between the interest rates of the two countries to carry out arbitrage operations. When you buy a currency with a high yield, you can get higher interest rates. At the same time, you will also face the risk of fluctuations in the foreign exchange market.


The interest rate parity Theory believes that in the case of differences in interest rates between the two countries, funds will flow from low-interest countries to high-interest countries to seek profits. But when comparing the returns of financial assets, arbitrageurs not only consider the returns provided by the interest rates of the two assets but also consider the changes in returns generated by the exchange rate fluctuations of the two assets, namely foreign exchange risk. Arbitrageurs often combine arbitrage with swap trading to avoid foreign exchange risk and ensure no loss. The result of a large number of swap foreign exchange transactions is that the spot exchange rate of low-interest country currencies floats downward and the forward exchange rate floats upward; the spot exchange rate of high-interest country currencies rises while the forward exchange rate falls. The forward spread is the difference between the forward exchange rate and the spot exchange rate, resulting in a forward premium for low-interest country currencies and a forward discount for high-interest country currencies. As the carry-on arbitrage continues, the forward spread will continue to increase until the yields provided by the two assets are completely equal. At this time, the carry-on arbitrage will stop. The forward spread is exactly equal to the spread between the two countries; that is, interest rate parity is established.


The interest rate parity theory means that you buy low- and high-yield currencies in the same way. For example, if the US dollar interest rate is 1.5% and the euro interest rate is 0%, you buy the US dollar, sell the euro, and prepare to hold the US dollar for two years. After two years, you earn a US dollar interest rate of 1.5%. However, the theory of interest rate parity points out that in the past two years, the euro has appreciated relative to the dollar because, during this period, arbitrageurs will carry out a large number of swaps to avoid foreign exchange risks and buy a large number of euros in the forward market, resulting in the rise of the euro forward exchange rate. Because of this, two years later, although the US dollar has an interest rate of 1.5%, its value relative to the euro has decreased.


In addition, the yield of a country's treasury bond often reflects the country's long-term interest rate expectations. When the price of a country's treasury bond rises, the yield will fall, and when the price of a treasury bond falls, the yield will rise. Arbitrageurs often refer to the yield of Treasury bonds when conducting arbitrage operations on two currencies. Arbitrageurs often search for relatively stable and less volatile currency pairs and then carry out arbitrage operations on these currency pairs, buying high-yield currencies and selling low-yield currencies.


Treasury bond yield and exchange rate

In the foreign exchange market, the market interest rate is usually based on the yield of a Treasury bond. Interest rates are divided into spot rates and forward rates. The difference between spot rates and forward rates is that the starting point of the interest date is different. The starting point of spot rates is at the current moment, while the starting point of forward rates is at a certain future moment.


Forward interest rates include spot interest rates and expected factors, reflecting people's expectations of interest rates for a certain period of time in the future.


The yield of a country's treasury bond often reflects its interest rate expectation, that is, its forward interest rate. The expectation of interest rates affects the fluctuation of the exchange rate. Exchange rate fluctuations are very sensitive to changes in the yield curves of the two countries.


For traders of fixed-income assets, the yield curve of a Treasury bond is very important. At the same time, the yield of treasury bonds also has an important impact on the exchange rate.


The figure below shows the interest margin between the yield of the 10-year US Treasury bond and the yield of the 10-year Japanese Treasury bond. There is a close relationship between the interest margins of the two countries and the dollar and yen.

Treasury yield

From the above figure, it can be seen that there is a correlation between the yield spread between the two countries and the fluctuation of their currency exchange rates. Although this correlation does not indicate that one variable varies depending on another variable, it at least proves a certain connection between the two. As can be seen from the above figure, the interest rate spread and exchange rate are mostly positively correlated, and sometimes there is a high degree of positive correlation.


The correlation coefficient ranges from -1 to 1, with negative values representing negative correlation, indicating opposite trends in the two, while positive values represent positive correlation, indicating consistent trends in the two. The higher the absolute value of the correlation coefficient, the higher the degree of correlation.


Central bank and inter-bank Interbank lending market rate

The central bank is the monetary management authority of a country, responsible for the formulation and implementation of the country's monetary policy. The central bank can control inflation levels by adjusting interest rates.


The inter-bank The term "interbank lending market refers to the interest rate used by one bank to lend funds to another bank in the interbank market.


The US Federal Funds Rate refers to the interest rate in the US interbank lending market, the most important of which is the overnight borrowing rate. This change in interest rate can sensitively reflect the balance of funds between banks. The Federal Reserve's targeting and adjusting the interbank lending market rate can directly affect the cost of capital of commercial banks and transfer the balance of funds in the interbank lending market to industrial and commercial enterprises, thus affecting consumption, investment, and the national economy.


The borrowing of federal funds is mainly carried out on a daily basis, and the interest rate level is determined by the supply and demand of market funds, with frequent fluctuations. This low interest rate and high efficiency (funds of the day and no guarantee) make the trading volume of the federal funds considerable, and the federal funds rate has become the most important short-term interest rate in the American financial market. The daily offer rate of federal funds is representative and an important parameter of the official bank rate and the preferential rate of commercial banks.


The Federal Reserve can influence the change in the federal funds rate through open market operations. When the Federal Reserve buys government bonds on the market, it will inject liquidity into the market, thus reducing interest rates. When the Federal Reserve sells government bonds, it tightens market liquidity, thereby increasing interest rates.


Inflation and interest rates

Inflation refers to the continuous increase in prices over a period of time. If the increase in prices is greater than the yield of a bond, bond holders often abandon the bond, causing a decrease in bond prices and an increase in yield. In general, an increase in inflation often boosts the stock market and causes funds to flow into it.


Inflation-protected bonds (TIPS) are an indicator of future inflation expectations, issued by the US Treasury Department and linked to the Consumer Price Index (CPI). The biggest feature of inflation-protected bonds is that they can eliminate the risk of domestic inflation in the issuing country and lock in the actual yield. The principal of inflation-protected bonds is linked to the CPI, and the principal portion is adjusted with the CPI index. The interest calculated at a fixed coupon rate will vary with changes in the principal. For example, if the yield of the 10-year US Treasury bond is 1.8% and the average inflation rate is 1.3%, then the actual yield of TIPS bonds is 0.5%. If inflation continues to rise and the yield of the 10-year US Treasury bond remains unchanged, the yield of TIPS will decline and the price will rise.


In addition, when inflation expectations rise, the Federal Reserve tends to raise interest rates and reduce lending activities. When inflation expectations decrease, the Federal Reserve tends to lower interest rates to boost the economy and stimulate employment. An increase in interest rates will lead to a decrease in the price of bonds or other fixed-income products, as the price and yield of bonds move in the opposite direction. For investors holding bonds, as inflation increases, interest rates also increase, which directly affects their earnings situation.


epilogue

Foreign exchange fluctuations are closely related to interest rate factors, and interest rates are one of the most important factors in fundamental analysis. Due to the existence of arbitrage activities, arbitrageurs often sell low-yielding currencies and buy high-yielding currencies, resulting in exchange rate fluctuations. There is a positive correlation between the interest rate difference and exchange rate fluctuations between the two countries, and the difference in interest rates between the two countries often drives changes in exchange rates over the long term. Therefore, it is also necessary to monitor the changes in interest rates in a country in order to trade its currency.

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