What are interest rates?

What are interest rates?

26 September 2014, 03:11
Ray Steve
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  • Future interest rate expectations take precedence over the headline rate
  • If a country has a high interest rate, but no further increases are expected, the currency can still fall.
  • If a country has a low interest rate but is expected to raise interest rates over time, its currency can still rise

While it is easy for Forex traders to understand the logic of why investors move money from lower yielding currencies and assets to higher yielding assets and currencies. They may also believe that the simple mechanism of supply and demand is responsible for currency movement. However, this is only part of the story. The expectation of future interest rate increases or rate cuts is even more important than just the actual rates themselves.


For example, the United Kingdom had interest rates that hovered between 4.5 and 4.75% which was much higher than the 3.25% in the United States. Conventional wisdom would dictate that GBPUSD should have went up during this time period. However, as seen in the chart above, this was clearly not the case as GBPUSD headed lower. The reason for this was the expectations that the US Federal Reserve would begin a rate tightening cycle. The 250 basis point premium enjoyed in the UK at the beginning of 2005 narrowed to just 25 basis point difference. The Fed raised the interest rate from 3.25% in December 2004 to 6.00% by May of 2006.

If a central bank decides to one day, hike rates and then say that they are through raising rates for the foreseeable future, then a currency can still sell off though the interest rate was raised.


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