Why should i buy the USD, if the US decides to raise their interest rate?

Thank you in advance!!

Hypothetical scenario here, on babypips school it says this…

“Let’s pretend the Fed announces they will raise interest rates. The market quickly starts buying the U.S. dollar across all major currencies….EUR/USD and GBP/USD fall while USD/CHF and USD/JPY rise.”

My question is an easy one, why when a economy raises its interest rates, should i buy that countries currency?

I am having issues understanding why anyone would do this? especially seeing as in an earlier lesson babypips wrote this…

“On the other hand, when interest rates are decreasing, consumers and businesses are more inclined to borrow (because banks ease lending requirements), boosting retail and capital spending, thus helping the economy to grow.”

If an economy grows because of a decreasing interest rate, as mentioned above isnt that better for the USD?

Please explain it like i’m 5 :slight_smile:

Thank you in advance!!

By raising Fed Funds rate the Central Bank increases borrowing costs of the Dollar making it more expensive currency. For example if you invest in certain asset which yields 0.25% using leverage, using leverage in Dollar then in case of rate hike by 25 b.p. from 0.25% to 0.50%your investments starts to yield zero profit to you as you have to pay additional 0.25% for borrowing of US currency.
Rate increase also affects bond prices which are falling as now lenders can receive 0.5% on new bonds, making bonds with smaller coupon less appealing. So bond prices will fall while their yield rise.

I did not really grasp any of what you just said, thanks for your reply anyway, will seek a clearer answer else where

Basically it means the economy is getting stronger. See when an economy starts to get weak people have less money to spend (typically speaking). So the government will lower interest rates so people will borrow. They thought behind that is if people can borrow money more easily they will do so and spend it which will stimulate the economy. By stimulating the economy people can borrow money to invest in there businesses or spend it pumping the money back into the economy. Problem is borrowing can get out of hand and to much debt is never good it is not sustainable over long term as you cant pay back borrowed funds with borrowed funds.

On the flipside if the economy is showing signs of strengthening then they will raise interest rates to curb borrowing so it dont get out of control. Also it is believed that the economy is strong enough people should have enough money not to need to borrow as much and in return pay back the debt they owe. This is sustainable for the long term.

Another thing to keep in mind to most governments use interest rates to control inflation. As interest rates are low people borrow and spend this causes inflation to creep up. When they raise interest rates people dont borrow and have to tighten there spending causing inflation to drop.

Personally I would not buy USD if they raise interest rates. Being a news trader is fine but spreads will go nuts with the knee jerk reaction that is sure to follow. This can cause slippage and stops to be missed. I would personally wait for the initial move to unfold (say about an hour after the release) once the knee jerk reaction is over the spreads will return to normal then I would sell into the initial rally as the markets will usually retrace its steps back to where it started before the release.

Also in my experience besides the initial knee jerk reaction. Interest rates tend to be more longer term movements and dont mean much right away to a day trader. Over time trends may shift directions in pairs like say USD/JPY as USD (assuming they raise interest rates) will have a positive rate while the Yen has a negative rate. I think I Yen is at -.25% so if they raise rates in the USD to say .75% then it will be appealing to large investors as the rollover will be 1% return on there investment a day. Thats not to shabby as long as you can survive the waves which most large investors have no problem doing.

One could write a book (or many books) about the purpose and impact of Central Bank interest rate policies. But a couple of isolated points here.

From a [I]foreign exchange [/I]perspective, we are more interested in the [I]international [/I]impact of a rate change rather than just domestic. Changes in interest rates will certainly affect domestic economic circumstances but does not cause US citizens to go out and buy dollars.

One impact of an increase in US interest rates means that the huge amounts of money held by international investment and pension funds will be redistributed to optimise their earnings by taking advantage of these higher rates. Investment funds will always be drawn to the best returns. If this means selling existing assets denominated in e.g. Euros and buying USD to invest in US Notes and Bonds then this creates demand pressure for USD. This is a totally simplified example and excludes related issues of risk and currency exposure issues. It may also increase foreign interest in investing in US corporate shares as the economy strengthens and company earnings improve - again requiring purchase of USD by foreign investors.

Also, Central Bank interest rate management is used to guide and direct an economy and its impact may take many years to take effect (like steering a huge oil tanker). An interest rate hike suggests the economy is strengthening which usually means that its export business is also improving as well as its domestic business. US foreign trade is probably almost always billed in USD and thus foreign buyers are buying USD to buy these goods and services.

So an increase in Fed rates will increase investment interest from abroad and indicate a likely increase in foreign trade levels as the economy increases. Speculative traders will anticipate that demand pressure and buy the USD now [I]before [/I]it happens.

On the other hand, when the Fed reduces rates, it is true that the intention is to boost the economy, but its impact might take years before it actually has any effect. And such a change in interest rates cannot be viewed in isolation. More often than not it will be only one stage in a whole series of incremental rate changes. Therefore a rate reduction is more indicative of ongoing economic weakness rather than an instant catalyst causing a sudden turnaround. Speculative money may see this as weakening investment and trade levels resulting in reduced demand for the currency from abroad.

Of course, these factors are only very small fragments in the overall jigsaw puzzle that makes up international currency supply and demand. But the main thing to remember it that speculative money reacts today on what it believes will happen tomorrow - even when “tomorrow” might be weeks, months or even years away.

There could be a never ending explanation about the impact of interest rate on currency, but let me provide you the main crisp reasoning why USD would rally if fed increase interest rate:

  1. Economy optimism: The only reason the fed would decide to press the green signal for interest rate hike if economic data continues to point to strong recovery in country’s growth. A rate hike means that US central Bank is much more optimistic about the economic growth prospect in country. Investors across the globe would take this as positive sign and would invest in economy for better growth prospect and for better return which means more demand for US dollar.

  2. Higher Investment Return: In today’s low yielding world where most of the developed countries are dipped in to negative interest rate regime to bolster economic growth, an interest rate hike in US would give better investment avenues for investors around the globe. Investors from Europe and Japan would divert their investments in to US notes and bonds for higher return. This would create demand pressure for US dollar means its value would increase.

  3. Currency correlation with interest rate: currency value is directly proportional to interest rate differential with respect to other side of the currency pairs. If interest rate in country increase the interest rate differential increase and leads to surge in the value of the currency with respect to other currencies due to decrease in supply or increase in demand.

If interest rates go up, it makes the “dollar’s value” go up. It’s because it becomes harder to borrow money (think interest rate in banks-when you take out a loan, it’s good for you if the interest rate is low bc it means you pay them back at a lesser rate than if it was high. everything is correlated in that fashion). To keep short, the dollar’s value will go up if int rates go up and it’ll go down if int rates go down. it’s a positive correlation.
BUTTTTTTT (and a big butt at that) you need to keep in mind that the FOREX marketplace operates on a
"exchange" basis. So it means that when the dollar goes up, a pair such as the EURUSD goes down!!! Think about it. If the dollar is more favorable, it means that you have more “dollar power” aka you can buy a single euro at less USD. if the dollar was weak and the euro had the upper hand, it would be harder to buy euros aka the exchange rate would go up. So in the scenario that we saw prior in the FOMC meeting when they announced that they were going to raise rates, it was almost a certainty that the eurousd pair (and others where the usd is the base) was going to tank. Vice versa if the USD is the base pair (USDJPY).

Let me know if that makes sense, or if it needs more clarification.
-John