THE MAIN INGREDIENT: INTEREST RATES AND INTEREST RATE DIFFERENTIALS

Interest rates are the “dough” of the fundamental forex pie. They are one of the most important factors that affect forex prices, as interest rates are the modern tool that central banks use as a throttle on their economies. The central banks of the world do not hesitate to use this important tool. In recent years almost all of the central banks increased interest rates. The European Central Bank raised interest rates eight times from December 6, 2005, to June 13, 2007, to a level of 4.0 percent to guide a booming European economy to slow down and avoid too high inflation. The United States’ central bank—the Federal Reserve—increased interest rates 17 times between June 30, 2004, and August 2006, and then paused when it decided the economy no longer needed the brake of interest rate increases.

Interest rate increases do much more than slow down an economy; they also act as a magnet to attract capital to bonds and other interest-bearing instruments. This has been called an “appetite for yield,” and when applied globally the flow of capital in and out of a country can be substantially affected by the difference in interest rates between one country and another. In recent years the outflow of capital from Japan to New Zealand, Australia, and Great Britain has reflected money chasing more yield and has been a major multibillion-dollar feature called the “carry trade.” The carry trade was driven by the interest rate differential that has existed, for example, between Japan (0.50) and New Zealand (8.0), causing low-cost borrowing in yen to invest in higher-yielding kiwis.

There can be no doubt of the critical role interest rates play in forex price movements. Some forex traders learned this lesson when the U.S. stock market sold off on February 27, 2007. It was precipitated by traders getting out of their carry trade positions. Since billions of dollars were sold to be converted back into yen, equity markets were also affected because equity positions had to be sold to buy back the yen positions. In Figure 1.1 we see how the Dow Jones Industrial Index correlated directly with the U.S. dollar–Japanese yen (USDJPY) pair that day.

FIGURE 1.1 Dollar Yen Slide Causes Dow Sell-Off.

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