Tuesday, July 27, 2010

central bank rate hikes bring currency up or down?


Higher interest rate helps a currency short-term. Inflation (sometimes associated with increasing IR) is sure to weaken a currency. According to Wikipedia -- By increasing interest rates a central bank stimulate traders to buy their currency (carry trades) as it provides a high return on investment and this would strengthen the currency against others.

I feel this might reduce inflation and increase purchasing power.When inflation is perceived to rise (easy borrowing), central banks dampen it by rate hikes (expensive to borrow).

Very roughly, Interest rate is 70% influenced by gov; FX rate is 30% influenced by gov. Central bank has 90% control on the supply of their currency (but not other currencies). FX adjustment is one of the goals of Central bank IR actions. IR actions have other serious consequences not to be ignored. In this sense, FX trading desk needs IR expertise.

The interest rate is higher on some currency because there is a probability that it will depreciate. As long as the depreciation does not materialize, the carry trade is profitable, but makes big losses when it does. High yielder currencies aren't always safe bets.

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