How Interest Rate Differentials Fundamentally Drive the Currency Markets

The foreign exchange market is the largest and most liquid markets with nearly 5-trillion dollars a day trading hands. There are many drivers of specific currency pairs. The most compelling is interest rates differentials.
Interest Rates

The differential between the short or long term interest rates of the countries that make up a currency pair is used to create the forward rate, and over the long term, help drive the direction of a currency pair. While most professional traders are keenly aware of the debt market and how it affects the currency markets, many novice traders are unaware of how interest rates drive currency markets movements.

What are Interest Rates

Interest rates are the amount that is charged for a loan. The interest rates that affect the currency markets are sovereign interest rates. A sovereign rate is an interest rate from a loan that a country issues in the form of bonds to provide the capital it needs to run its country. Generally, when economic strength is pervasive, interest rates will increase, and when an economy contracts, interest rates generally decline.

Bonds, which are loans, are issued for many different tenors. Countries will issue short term notes or bills that can be as short as overnight rates, as well as terms that last for 30-years. The most actively traded bonds are those from developed countries such as the United States, Japan, and Germany. Emerging countries also have bond markets but those instruments are less liquid.

How Do Interest Rates Make Up the Forward Curve

When you purchase or sell a currency pair, you are buying one currency and simultaneously selling another currency. The majority of the currency transactions that take place globally are within the spot market. Spot market transactions settle within 2-business days. If you are interested in holding a currency transaction longer than 2-business days, you need to transact a forward trade. Forward trades add forward points to a currency pair that is transacted for three or more days.

To calculate the forward rate, currency traders use the interest rate differential. This is the difference between the short term interest rates of each of the countries that make up the currency pair. For example, if you purchase the USD/JPY currency pair, you would receive the US dollar interest rate, and need to pay away the Japanese short term interest rate.

Forward points are added or subtracted from the currency pair.  You would first need to determine which rate is higher. Currently, US dollar interest rates are higher than Japanese interest rates.  In using the example of the purchase of the USD/JPY, you would subtract the forward points from the rate which would provide a new rate that incorporated the forward points.

What Effects the Interest Rate Differential

There are several factors that drive the interest rate differential. Obviously, monetary policy changes are key to changes in countries interest rate levels. Since market forces drive interest rate levels, changes to economic data are also a key factor. For this reason, you might want to follow an economic calendar to determine if there are specific events that will drive the future direction of rates. In addition to economic events and policy changes, political strife can also drive interest rate levels. When there is uncertainty within a country, the markets will demand more from a country to lend them money.

Most developed bond markets move in tandem with one another. There are plenty of occasions where a specific event will alter the course of a countries interest rates, but when there is little new information available, most developed bond markets will move in tandem. Historically, the US bond market is the driving force behind most of the rate movements globally.

How Does the Interest Rate Differential Effect the Currency Pair

Interest rate differentials can be a benefit or deterrent when you determine to purchase or sell a currency pair. For example, if you are planning to either buy or sell the USD/JPY for 2-years, you will either receive 2.68% by purchasing the greenback, or pay away 2.68% if you purchase the yen and sell the dollar. This is because the 2-year US rate is 2.50% and the Japanese 2-year yield is -0.18%. If you buy the dollar and nothing happens for 2-years you will earn 2.68%. If you buy the Japanese yen and sell the dollar and nothing happens for 2-years you will lose 2.68%

Charting the Interest Rates Differential

One of the best ways to follow the interest rate differential is to chart it. Each currency pair reacts differently to changes in the interest rate differential. What is important to remember is that the differential works in tandem with the currency pair, so you are looking to see what the future interest rate differential will be.

You can see from the chart of the US 10-year yield versus the Japanese 10-year government bond yield that the interest rate differential trades in tandem with the USD/JPY currency pair. While there are times when the 2-assets diverge, over time they move in tandem with one another.

Many have asked the question, does the rate differential drive the currency pair, or does the currency pair drive the interest rate differential. Since the interest rate differential makes up the forward rate, the answer is both. What you want to evaluate as a trader is whether the currency pair is moving in one direction and the interest rate differential is moving in another.

Summary

The interest rate differential is the driving fundamental force behind the movements of currency pairs. The interest rate differential makes up the currency forward curve and therefore is an integral part of currency trading. Monetary policy, economic events, and political strife are the key factors that drive interest rates. To get a gauge of where the interest rate differential is relative to the currency pair you can chart the two. What you are looking for is a situation where the path of the interest rate differential and the currency pair have diverged, which might give you clues to the future direction of the currency pair.

Author: Fundamentals Translation

Fundamentals Translation, a division of the BelTranslation International Group, helps forex brokerage firms expand to 70+ global markets. Since 2002, we have been offering translation & localization services: fundamentals analysis, financial reports, broker reports, weekly market outlooks, webinar content, website text, and training material translation to our global clients. We proudly work with leading forex brokerage firms such as Swissquote, London Capital Group, trade Berry, TRADEMOTE, TRADEHOUSES.

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