Standard monetary policy dictates that a real interest rate differential between two currencies will cause the currency with the higher rate to appreciate vs the currency with the lower rate. The savings rate would tend to increase in the country with the higher rate and so capital inflows into this economy causes an increase in demand for the economy’s currency.
It’s important to note that I’ve mentioned the real rate here. This refers to the interest rate with inflation included. You could have a 5% interest rate, but if inflation is running at 10%, this differential will most likely lead to a depreciation of 5% (as well as there most probably being geopolitical factors that are causing a 10% inflation rate that would dissuade investors from investing in the country with the higher rate). A country with a 2% inflation rate and a 3% interest rate would probably lead to an appreciation in the currency of 1% – therefore it’s more advisable to invest in the country with the currency that is more stable.
But, the US Dollar is another story. Historically, the USD falls after a hike, but rallies hard before. A friend of the FX Guys, David Belle, wrote an article on EURUSD where he foresees a rally to 1.22 (current level is 1.08). But the US have just hiked! They have, but this hike is priced in. This means that the currency appreciation from a rise in rates occurred before the hike – the hike occurs and because expectations are fulfilled, the dollar falls off.
A strategy that longer term investors use is called carry trading. This is when you find a currency with a high interest rate spread and borrow a lower interest rate yielding currency in order to benefit from both price appreciation and the rollover.
This is a perfect example of a carry trade that many traders benefited from in mid 2000s. The Fed raised rates pretty aggressively during this period while the BoJ kep rates at 0 (the BoJ has been in a deflationary quagmire for many years now, so a rate hike was definitely not on the cards). Traders who caught this would have experienced a gain of 19%. Of course it’s very unlikely you’ll catch any move from top to bottom, but this is the gain produced from this carry trade.
