The most important overall determining factor in establishing one currency’s value against another is the direction of monetary policy as this will drive interest rates. Whilst this policy is primarily aimed at influencing domestic interest rates this has an impact in terms of the relative interest of one currency against another.
Furthermore domestic interest rates have an influence over the economic performance of an economy, with low interest rates stimulating borrowing, consumption and investment.
Interest rates influence the global flows of capital and are benchmarks to what investors can be expected to earn in a particular country.
It’s not just current interest rates that interest forex traders but more importantly, in which direction rates are headed. Interest rate expectations can shift suddenly based on a single economic report or survey.
Remember though, in forex trading the market is focused on currency pairs. i.e. one country’s currency valued against another. So, in this case the interest rate differential is the key figure. It’s quite possible that the interest rates for a particular currency pairing move in opposite direction which can amplify the effect on pricing.
Another important factor to consider is the level of real interest rates, that is, after inflation has been taken into account. So, if a government bond in a particular country yields 8.5% and yet inflation is running at 4.5% the real yield of the bond is only 4.0%.
This is especially important in times of rampant inflation or deflation. Interest rates in a country may be as high as 20% but if inflation is running at a higher level then investment yields are less than zero. On the other hand if deflation has taken hold zero rate interest will still yield positive returns.
