How Interest Rate Increases Drive Currency Spikes
Posted on 05. Apr, 2007 by admin in Forex Basics, Forex Market
A common way to think about U.S. interest rates is how much it’s going to cost to borrow money, whether for our mortgages or how much we’ll earn on our bond and money market investments. Currency traders think bigger. Interest rate policy is actually a key driver of currency prices and a great starter strategy for new currency traders.
Fundamentally, if a country raises its interest rates, the currency of that country will strengthen because the higher interest rates attract more foreign investors. When foreign investors invest in U.S. treasuries, they must sell their own currency and buy U.S. Dollars in order to purchase the bonds. If you believe U.S. interest rates will continue to rise, you could express that view by going long U.S. Dollars.
If you believe that the Fed has finished raising rates for the time being, you could capitalize on that view by buying a currency with a higher interest rate, or at least the prospect of relatively higher rates. For example, U.S. rates may be higher than those of Euroland now but the prospect of higher rates in Euroland, albeit still lower than the U.S., may drive investors to purchase Euros.
