[Definitive Guide] 'Interest rates have risen' alone does not determine the direction of a currency
‘Interest rates have risen. Therefore, the currency should be bought.’
This way of thinking is half right and half wrong.
Have you ever had the experience of buying a currency after seeing news that interest rates had risen, only to have it sold off instead?
In a previous article, when discussing the ladder of risk assets, I divided the causes of interest rate hikes into three categories. This time, I will delve one step deeper into the point that is most easily confused among them. Even with the same ‘interest rate hike,’ the currency will move in the exact opposite direction depending on the underlying cause.
First, a way to distinguish them
I will state the conclusion first.
When interest rates move, always look at them in conjunction with the currency.
If interest rates rise + currency strengthens, it is a healthy rise.
If interest rates rise + currency weakens, it is possible that the market is beginning to question the country’s creditworthiness.
If you reflexively think ‘buy the currency because interest rates have risen,’ you will be caught on the wrong side in the latter scenario.
I will look at why these two things happen in order.
Rate hikes where the currency is sold versus rate hikes where it is bought
Even with the same ‘interest rate hike,’ the content can be completely different. One is a warning signal, and the other is a healthy sign. The key to distinguishing them is which reason is causing that interest rate rise.
When interest rates rise as a result of ignoring prices
First, let’s start with the currency weakening pattern.
Imagine a situation where prices are rising, but the central bank is hesitant to raise interest rates.
The flow goes like this.
Inflation is high but they don’t raise rates
→ The value of cash falls
→ The value of government bonds, which are close to cash, also falls
→ Stocks are bought and government bonds are sold
→ yields rise
At this time: Government bond yields ↑ Currency ↓ Stocks ↑ Gold ↑
If interest rates are not raised even though prices are rising, the value of cash will diminish. Since government bonds are assets close to cash, their value falls for the same reason, and they are sold. On the other hand, stocks are bought because if prices rise, sales will also increase in monetary terms. The movement of selling government bonds to create funds to buy stocks also overlaps.
There is a point to remember. The selling is not concentrated in short-term maturities like 2-year bonds, but is concentrated in ultra-long-term bonds (such as 30-year bonds). The reason is simple. With a 2-year bond, the funds return in two years and can be moved to other assets. Since a 30-year bond remains as is for 30 years, the time exposed to price increases is orders of magnitude greater.
The longer the loan term, the greater the portion eaten away by inflation.
If you feel that it is strange that interest rates are rising even though stocks are rising, please remember this pattern. The fact that stocks have become attractive is itself a reason to sell government bonds.
And even though government bonds are being sold and interest rates are rising, the currency is not being bought. It is actually being sold. This is the true nature of ‘rising interest rates but a weaker currency’.
In the case of a healthy rate hike due to a strong economy
Next is the pattern where the currency strengthens.
The flow is as follows.
Economy is strong, or central bank moves toward tightening
→ Real interest rates rise
→ The appeal of investing in that currency increases
→ the currency is bought
At this time: Government bond yields ↑, Currency ↑, Gold ↓, Stocks depend on the reason
This is a healthy rise in interest rates. Because the economy is strong, or because the central bank has moved to tighten, real interest rates (nominal interest rates minus the inflation rate) rise. As a result, the appeal of investing in that currency increases, and funds gather.
Even with the same rise in interest rates, here is how to tell them apart
As a phenomenon, both are just ‘interest rates rising.’ But, they are surprisingly easy to distinguish.
All you need to look at is which way the currency moved.
There are two reasons for a rate hike
There is one more point to note.
Even with the same news of a ‘rate hike,’ the effect changes depending on whether the reason is ‘because the economy is too strong’ or ‘because prices are too high.’
In the former case, stocks can also rise. The premise that the economy is strong is itself a tailwind for corporate performance.
In the latter case, stocks are more likely to be sold. This is because a rate hike to curb prices is nothing more than an increase in costs for companies.
When reading news, please look at ‘what is written as the reason.’ Even with the same rate hike, the impact on stocks changes.
Connection to the previous article
Previously, when we covered the ladder of risk assets, we divided the causes of interest rate hikes into three categories.
-
Cause 1: Rise in real interest rates (healthy rise)
-
Cause 2: Rise in expected inflation
-
Cause 3: Concerns about credit and fiscal policy
The current “rate hike due to economic boom” is precisely the concrete mechanism of Cause 1. And “rate hikes due to ignoring prices” corresponds to the internal structure of why Cause 3 (or 2) leads to currency depreciation.
Even with a single piece of news saying “interest rates have risen,” the amount of information you can see changes completely depending on whether you can break down the reason behind it.
Summary
1. When interest rates move, always look at them in conjunction with the currency
If interest rates rise and the currency strengthens, it is healthy. If interest rates rise and the currency weakens, credit may be in question.
2. Expectations of rate hikes while ignoring prices lead to selling of ultra-long-term government bonds
If a central bank hesitates to raise rates, the value of both cash and government bonds falls. Selling concentrates on the ultra-long term, which is exposed to rising prices for a longer period.
3. Rate hikes due to economic boom and tightening raise interest rates healthily
Real interest rates rise, increasing the appeal of investing in that currency. The currency is bought.
4. The impact on stocks changes depending on whether the reason for the rate hike is “the economy” or “prices”
Rate hikes driven by the economy can see stocks rise as well. Rate hikes driven by prices tend to lead to stock sell-offs.
5. There is only one procedure for distinguishing them
When you see news about interest rates, check which way the currency moved.
Conclusion
The news that “interest rates have risen” actually says nothing on its own.
The reason for the rise—is it the economy or prices? Only by breaking this down can you get an idea of which way the currency will move.
If you learn by reflex that “interest rate hike = currency buy,” you will be caught off guard in situations where prices are ignored. Conversely, if you make it a habit to verify the reason, you will be able to extract more information from the same news.
If you only look at charts, you may end up not knowing why the market moved suddenly. Even if you only follow news headlines, you won’t understand why the same “interest rate hike” produces opposite results on different days.
What is important is not collecting information, but deciding the order in which to break down the content of the same words.
For those who want to learn FX systematically from the basics, or who want to organize the connection between interest rates and exchange rates, I recommend that you take a moment to organize the learning content you need. Just by deciding the order, the way you see the news will change significantly.
Thank you for reading until the end.
*This article is educational content intended for learning FX. It does not provide instructions for trading decisions, nor does it recommend any specific methods or timing. The market mechanisms described are general explanations and are not guaranteed to apply in all situations. FX involves the risk of loss of principal and other losses; please make investment decisions at your own risk.