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FX101: Interest Rates

In Business and Currency by Continental StaffLeave a Comment

Interest rates, what could be more exciting? If you follow our weekly news roundup, Headlines (and who doesn’t!), then you know that we pay a lot of attention to interest rates. You also know that last week the Federal Reserve raised their interest rate by a whopping 0.25% to between 0.75% and 1%. But you might not know why it all matters, or why anyone cares about a measly 0.25% increase.

Well you may not think that interest rates are exciting, but they do play a big part in your life whether you realise it or not.

What are interest rates?

We all know what interest rates are when discussing loans, credit cards, or mortgages, but when talking about central banks interest rates means something different (although related). Setting the interest rates for a country determines how much the central bank charges commercial banks to borrow money, which is why it is also sometimes known as the bank rate. Commercial banks who want to loan each other funds must also charge the bank rate as a minimum. This is effectively the cost of money. The lower the bank rate the lower interest that banks offer for savings accounts, which is bad for savers, but a lower rate also means that banks charge less interest on loans and mortgages.

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Why do banks raise and lower rates?

Low rates encourage borrowing, because banks charge less for loans and mortgages, but discourage saving, because you won’t earn very much interest.

High rates encourage saving, but discourage borrowing because interest rates on loans and mortgages will be higher.

When the economy is not doing well the central bank may set rates low, to encourage people to take their money out of their savings accounts and spend it, put it in the stock market (or other more lucrative financial products), or use it to take out a loan. The idea is that this will increase liquidity (less money locked away in savings), promote consumer spending, and boost businesses and the stock market.

When the economy is doing well the central bank may raise interest rates. This will encourage people to put their money into savings accounts where they will earn higher interest, and discourage spending and investing. But why would they want to slow the economy? Bubbles and inflation.

Bubbles

What goes up must come down, and when borrowing money is super cheap then people will buy bigger houses than they otherwise would be able to afford, make riskier stock bets, and companies will become dependent on it (i.e. instead of becoming better companies they will just support themselves with cheap loans and investments from risk-taking investors). Raising rates slowly will steady the markets. Alan Greenspan (Chairman of the Federal Reserve from 1987 to 2006) was famous for using interest rates to engineer ‘soft landings’ where raising and lowering rates was used to stoke and cool the economy… until the dot-com bubble bursting in 2001 and the housing market crash of 2007 proved that his methods were not as foolproof as everyone thought.

Inflation

When there is a lot of money floating around then the price of goods and services increases. Some inflation is good (most developed countries aim for 2%) but rampant inflation means something that cost $1 yesterday and $2 today might cost $3 tomorrow. Rampant inflation is the thing that central bankers fear most.

We’ll talk more about inflation later, but let’s get back to the main question, one that we hear all the time from our clients:

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How do interest rates affect currency exchange?

Interest rates are not the only factor determining currency exchange rates, but they can play a significant role. All else being equal, higher exchange rates will increase the value of a currency, and lower exchange rates will diminish the value of a currency.

Foreign demand

Higher interest rates incentivise saving and increase demand from foreign investors. The more demand there is for a currency, the higher the price. Lower interest rates are less valuable to foreign investors who may then choose to invest in a different currency, reducing demand and decreasing prices.

Think about it, if banks in Country A were offering you a 3% return and banks in Country B were offering 1%, where would you put your money? In some cases traders may even borrow money from Country B and invest it in Country A for a 2% profit!

Inflation

Unfortunately it is not that straightforward. Raising or lowering interest rates impacts the wider economy, which in turn influences the value of currency.

Inflation is a key factor behind currency exchange rates. Low interest rates promote growth, and high interest rates make borrowing more expensive (and saving more lucrative), slowing growth. Generally faster growth causes inflation, and slower growth reduces it.

Imports and Exports

Low inflation will make a country’s exports more competitive (and make imports less competitive – so people will buy more domestic goods), and when a country exports more than it imports then the value of its currency will strengthen. This is because businesses, people, and institutions in other countries will all have greater demand for their currency.

High inflation, conversely, causes goods to cost more and therefore makes them less competitive against imports. A country with high inflation will thereby export less and import more, lowering the demand for their currency and depreciating its value.

Exchange rates affect inflation

Of course when it comes to currency exchange nothing is ever that straightforward. The relationship between exchange rates and inflation is a two way street. Exchange rates can affect inflation, as much as inflation affects exchange rates.

As the value of a currency decreases, inflation increases. This is because the price of imported goods will increase (since the currency you use to buy them is worth less) which also will boost demand for domestic goods (which will now be more competitively priced compared to imports) and exports will increase. As exports increase so too will the value of the currency, and inflation will rise. It is a complex reciprocal relationship.

Inflation affects different types of economies in different ways. For larger, more self-sufficient economies (like the US in which imports account for only about 15.4% of GDP according to the World Bank), inflation has less of an impact on foreign exchange. In the UK, where imports account for 29.3% of GDP the impact is much greater.

2% Central Bank Target

Inflation affects currency exchange in another way. Most developed economies aim for an inflation rate of 2%. Anything lower means that there is not enough growth, and anything higher means that prices are going up too quickly.

When inflation is below that target, central banks cut rates – which also reduces the value of their currency. When inflation is above 2% (or closing in on 2%) they raise rates to cool the economy, causing the currency to gain in value.

Currency exchange rates, balance of trade, inflation, interest rates, and a myriad of other factors all impact one another. Economics is complex and far from an exact science, which is why central bankers are so cautious, and why trying to time your currency exchange can be difficult.

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Why have Interest rates remained low?

In the US, Canada, UK, and other Western countries interest rates have been held to near record low levels due to the financial crisis of 2007-2009. To prevent an economic collapse during the crisis the US Federal Reserve, the Bank of Canada, and the Bank of England all cut interest rates in order to encourage spending, investment, and lending. In order to aid the recovery,rates were kept low (and other measures like quantitative easing, and huge bailouts were also implemented).

From 2007 to 2015 US interest rates were kept at rock-bottom levels of 0% to 0.25%. Canadian interest rates dropped from over 4% in January of 2008 to just 0.25% in April of 2009. In 2010 the Bank of Canada raised rates back up to 1%, but the oil crash forced rates down to 0.5% in 2015 where they have remained ever since.

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Using Continental’s Rate Watch you can see that as interest rates declines, so too did the CAD. Remember that other factors, like low oil prices and a strong USD, also kept the loonie down.

Why has the USD remained so strong despite low rates?

Hold on, if the US interest rates were kept so low between 2008 and 2015 then why is the USD so strong?

Low interest rates in the US haven’t drastically affected the USD because other major currencies, like the pound, Canadian dollar, and euro have also had low interest rates. On top of that, the USD is the world’s most common reserve currency. That means central banks from Canada to China all have huge quantities of USD, and use it for international transactions, so even when the US economy isn’t performing well, and interest rates aren’t high, the USD will retain value – making it what is known as a safe-haven currency or hard currency. This reputation in turn reinforces the USD’s safe-haven status. Since the USD is considered a safe currency investors flock to it (along with other holders of value like precious metals) when there is trouble in the stock market.

That is why the USD started the year at the highest level in 12 years.

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Why do central banks move interest rates so slowly?

Central banks are incredibly cautious when it comes to raising interest rates – and for good reason. A sudden increase can send the markets crashing, businesses that rely on short term loans will suddenly be faced with extra expenses, and long term loans like mortgages will also cost more.

When interest rates are low people are more willing to take risks in the stockmarket, but when rates rise they will be more cautious. Similarly investors may also pull money out of the stock market and put it into either banks to earn interest, or into the currency market.

Central banks are reluctant to raise rates unless there are strong economic indicators across the board for fear of upsetting the economy and inducing a recession. In the 1920s the Fed raised rates in the midst of the Great Depression. Their goal was to curb market speculation, but it inadvertently prolonged the suffering for millions of Americans.

Cutting rates, or failing to raise rates at the right time, is also potentially dangerous. Cheap money leads to more speculation and could result in high inflation or dangerous bubbles.   

What do interest rate changes mean for me?

When a central bank raises interest rates, you can expect to earn more from your savings. Sure a 0.25% bump may not seem like much, but it is still better than nothing! For us Canadians every time the Fed raises rates we can expect to see the USD pull further ahead of the CAD, and every time the Bank of Canada raises rates the CAD should strengthen.

A stronger CAD may not always be a good thing. Sure it is great for shopping down south, but it is bad for Canadian exports, and allows imports to compete with Canadian-made goods. A high USD may irk many Canadians, but it means more American shoppers, and more exports south of the border. Many experts have accused China of manipulating their currency for this very reason – a low currency makes their exports more competitive.

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What effect will a strong USD have on emerging markets?

Many emerging economies have been slaughtered by the USD recently. The greenback continues to move further and further ahead while emergency currencies are naturally depreciating due to economic issues. Higher rates could lead to even weaker emerging market currencies.

What do central banks look for when determining rates?

Generally central banks use the Consumer Price Index (CPI) which measure the price of goods (inflation), the housing market (rapidly rising prices can be dangerous, increasing interest rates makes mortgages more expensive and discourages speculation and new buyers), consumer spending (cut rates to increase spending, increase to slow spending), unemployment (cut rates to encourage lending and new businesses to increase employment), and other indicators of economic health.

Unless you want to follow all of the latest economic reports then the best way to figure out whether or not a central bank will raise rates is to pay attention to the latest analysis, or wait for a major announcement. Central bankers don’t like shocks (except for Paul Volcker!) so they will hint at a potential rate rise long before it happens. There are of course, exceptions. In 2008 the Bank of New Zealand defied all of the expert analysis by cutting rates from 8.25% to 8%. Not a huge drop but enough to cause the NZD to drop from US 0.7497 to US 0.7414 in around 10 minutes!

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What are negative interest rates?

The Bank of Canada has said numerous times that it would consider implementing negative interest rates if necessary. Japan, Sweden, Switzerland, and the European Central Bank have all already used negative interest rates.

Usually central banks pay a small amount of interest to banks to store their money, so a 0.25% interest rate gives commercial banks $25,000 for every $10 million they store. Negative interest rates flip this principle on its head. Negative interest rates force commercial banks to pay central banks interest for allowing them to hold their money. So a -0.5% interest rate would mean that banks pay $25,000 for keeping $10 million at the Bank of Canada.

The reason for all this? To force banks to do something with all their money! Parking it at the Bank of Canada would only eat up their profits so they may as well invest it, loan it, and push it back into the economy.

Critics, however, argue that this could lead to greater costs for consumers. On the flip side, it may also mean prime lending rates as low as 1%.  

When should I buy currency?

Timing your currency purchases around central banks is not exactly the most practical strategy unless you are a currency trader. Currency values will generally reflect what the markets think the central bank will do followed by a slight boost once that is confirmed. If the central bank pulls a surprise move and suddenly decide to go against the prevailing market opinion then expect prices to change drastically – but central banks are notoriously cautious so don’t expect for this to happen regularly. New Zealand unexpectedly cut their rate in 2008 which sent their currency free-falling, before it recovered not long after.

Buying your currency before a rate rise will usually be cheaper than buying it after, and selling before rates are cut will be better than selling after. When buying currency the most important thing is to find a trusted currency exchange provider that does not charge hidden fees.

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