The Relationship Between Fx Rates And Interest Rates

Think currency rates have nothing to do with stocks? Think again. They are actually quite close relatives, especially the relationship Nasdaq or Dow Jones and the US Dollars, Yen as well as Yen crosses. If you follow daily foreign exchange news, you will notice phrases such as “Yen and Dollar retreat as stock market rise” or “Yen crosses got hammered as stocks plunged.” As a matter of fact, professional traders already accept this phenomenon as an indisputable fact that they don’t see the need to mention it in the news.

Let me give some more examples. Four months ago before the bulk of bad financial news were released to the media, the USD and JPY were doing so badly, where the EUR cost about 1.50 USD, and it took more than 180 Yens to exchange for a British Pound (GBP). But things fell apart abruptly in matter of days, when the US government officially announced that the recession had already started a year before. Shortly afterward, several large banks collapsed around the world that quickly pulled down all stock markets. And as you could see, the USD quickly gained ground among all counterparts (except JPY), and the Yen also appreciated in the same manner. Today as I am writing this, a EUR is worth 1.30 USD (after it dropped to as low as 1.22 a few weeks ago), and a Sterling can be exchanged for only 146 yens.

But that was what happened during a four-month period. You can actually see these exchange rates fluctuate almost instantaneously with stock markets every day. The first question a novice trader may want to ask is “WHY?” Most trading experts agree that Forex market is much like stock market in terms of speculation, where price action depends much on anticipation of what will happen, instead of what already happened, or what is happening at the time being. In other words, it’s the traders’ mood that move the market. If traders feel good about the economy, they buy stocks as investment; whereas when the financial future seems to be threatened, they sell. And when there are more buyers than sellers, the demand is up, and so is the price. The Relationship Between Fx Rates And Interest Rates

The nature of forex market, however, is a little more sophisticated. When you deal with foreign exchange, it’s always involved at least two different economies (or countries), not only one as in stock market. So the exchange rates are affected by both economies involved (in each currency pair). For example, when you trade the pair GBP/JPY, you have to watch out for what’s going on in both Japan and England. Now, that’s only the basics. The funny thing is, while there’s nothing much going on in either of these two countries, this currency pair is actually moved by what happens in America! Reason? It’s the “risk factor” that affects then Yen, which in turn affect this pair’s rate.

So what is actually the “risk factor”? The risk factor of a currency depends on both geopolitical stability and interest rate. When there’s nothing of warfare nature going on, this risk factor depends mostly on interest rate. JPY has been considered low risk because it has the lowest interest rate among the majors: only 0.10%, followed by the USD at 0.25%. On the other end, you may see the higher risk currencies such as NZD and AUD. To get more return, traders borrow the low-interest Yen to invest in higher-interest currencies, the activities known as carry trades. The US dollar, however, has always been considered low risk (and hence, low return) mostly because of the size of the US economy. When you buy a treasury note (underlying the stability of the USD), you’ll know it’s the safest investment you can get. The reason is that as large and strong as the US economy, the USD will not likely evaporate in thin air.

With the risk factor in play, traders value USD and JPY more when they perceive more risks in the market (stock market down). On the other hand, when the economy is perceived as stable, they would dump these low-risk currencies in search of higher-return counterparts, the concept known as “risk appetite” in the trading world. In conclusion, if you narrow your forex portfolio down to major pairs and Yen-crosses, then you need only look at the stock market to make your trading decisions.

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