Have you ever considered why currency prices move up and down? If you have been trading for any length of time, you understand that currency values move according to all sorts of factors. They move due to scheduled news releases, they can definitely move quite strongly due to unexpected news events, they can move based on technical levels and they can move on a daily basis due to a host of other reasons. When an international firm engages in the acquisition of a foreign company, it will have to buy and sell potentially hundreds of billions of currency, and this will cause the market to move to some degree. However, these things only move currencies in the short-term. Over the long-term currencies are driven by interest rates.
The Importance of Yield
The primary duty of every fund manager in the world is to make money for clients. Therefore, fund managers must produce positive yield each year. Each currency has an interest rate that is attached to it, which is set by its Central Bank. Therefore, the Federal Reserve, which is the Central Bank in the United States, sets interest rates for the U.S. dollar every month. Fund managers, banks, and very wealthy investors pay close attention to the changes in this interest rate because it determines how much yield they can get for their investment in that currency.
If a fund manager is given the choice of two different investment opportunities, with both having relatively the same amount of risk, which one will the fund manager choose? Of course, he is going to choose the investment opportunity with the highest yield potential, and this is exactly why interest rates drive currency value over the long-term.
Follow the Capital Flows
Investment capital tends to flow into a currency with a high interest rate because investors are in search of higher yield; conversely, capital tends to flow out of a currency with a low interest rate because there is little incentive for investors to hold the currency at a forex broker if they are not earning any yield.
This Weekly Chart of the AUD USD shows price action from March 2001 through December 2007. You can see that the Aussie made a massive move against the dollar over the course of these 6 years. In 2001, the AUD/USD was trading at 0.4850 and by the end of 2007, it was trading at 0.9400. That means that during this 6 year period the AUD/USD moved up over 4,500 pips!
During this time period, the Federal Reserve, headed by Mr. Alan Greenspan, pursued very loose monetary policy and kept interest rates at very low levels. During the same 6 years period, Australia’s economy was growing very aggressively, and the Reserve Bank of Australia had to keep interest rates very high in order to stem inflation. This very wide interest rate yield spread led to a massive appreciation of the Aussie dollar versus the U.S. dollar.
Pairing Individual Currencies By Interest Rates
One way to strategically play interest rates in the forex market is to purposefully pair a very low-yielding currency pair and a very high-yielding currency pair. By buying the high-yielding currency pair and simultaneously selling the low-yielding currency pair, a trader can take advantage of the yield spread between the two currencies and possibly catch an appreciation in the high-yielding currency. This trading strategy is known as the carry trade—which is traditionally defined as borrowing money in a low-yielding currency and then buying a high-yielding currency. This strategy tends to do quite well during times of high risk appetite, but when risk aversion hits the market, investors liquidate risky positions and the carry trade falls apart