You will be wondering what the factors that influence market sentiments are. Interest rates play a major role affecting the supply and demand of currencies in the global financial markets. Trends in interest rates are one of the most significant factors influencing market sentiment.
Every currency in the world has an interest rate attached to it and these interest rates are decided by the respective central banks. FED determines the interest rates in US. Bank of Japan determines the interest rates in Japan. Similarly the Reserve Bank of New Zealand determines the interest rates in New Zealand.
Some governments want more foreign investment. Those currencies will have a higher interest rate. Investors are always looking for a better interest rate yield on fixed income securities. These currencies will attract the most attention from the savvy international investors. Global movement of money also depends on the economic and geopolitical risks between countries.
The value of money decreases when there is an upward revision of prices of most goods and services in the country. You will ask what causes fluctuations in the interest rates. In simple terms, inflation!
Central banks control inflationary pressures by increasing the interest rates. Similarly in times of deflation just like the present when the global economy is in a recession, the Central Banks will decrease the interest rates. Central banks are responsible for ensuring the price stability in the domestic economies. Monetary policy is an important tool for the central banks.
Suppose the inflationary pressures are increasing in the US economy. FED would raise the Federal Fund Rate. Federal Fund Rate is the rate the banks charge each other for overnight loans. When overnight rates changes, retail banks will adjust their prime banking rates! This accordingly affects businesses and individuals in the economy.
The most important way in which interest rates can affect the currencies is through the widespread practice of carry trade. A carry trade involves shorting of a low interest rate currency to go long on a higher interest rate currency in order to gain the difference between the two interest rates. This difference is known as the Interest Rate Differential.
The trader is paid the interest rate on the currency on which he/she is long. He/she must pay the interest rate on the shorting currency. So you can see currencies with higher interest rates are highly sought after by investors looking for a higher return on their investments.
As a general rule, rising interest rates tend to strengthen a currency relative to other currencies as investors tend to shift their assets to higher interest rate currency. They have to buy that currency for that transfer of assets. This increased demand for the currency pushes the currency price relative to other currencies.
In 2005, Japan was offering almost zero interest rates on Japanese Yen deposits. There was a lot of interest in Japanese investors to invest in New Zealand dominated assets. NZD was paying a higher interest rate as compared to the near zero interest rate being offered on JPY. The interest rates had been made almost zero by the Bank of Japan to fight a decade long deflationary cycle and kick start the economy again.
So in general rising interest rates should boost the market sentiment for that particular currency. The opposite is also true and interest rates cut would result in bearish sentiments regarding the currency of that country.
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