The fundamental rule in the foreign exchange market states that interest rate hikes strengthen a currency, while interest rate cuts weaken it. Although this correlation has been observed in the past, recent developments also highlight its limitations. Mathias Beil, Head of Private Banking at Sutor Bank GmbH, points out that interest rates have often lost their dominant role over currencies recently. He attributes this to investors not basing their decisions solely on interest rates. Instead, political frameworks, the state of public finances, general risk assessments, and interest rate differentials compared to other currency areas are included in the analysis.
Interest rates are undoubtedly a relevant factor for exchange rate development, but never the sole one. What is crucial, according to Beil, is why interest rates are rising and what specific risk the investor is taking on. The underlying mechanism is simple: rising interest rates in a country or currency area increase the attractiveness of capital investments, which should lead to increased demand for the respective currency and consequently to an appreciation.
A striking example was provided by the US central bank, the Federal Reserve, which raised its key interest rate from 0.25 to 5.5 percent between March 2022 and July 2023. During this period, the US dollar gained approximately 15 percent against a weighted basket of major currencies, and capital increasingly flowed into dollar-denominated assets. The euro temporarily fell below parity with the dollar. A strong reaction was also observed in Turkey when the central bank raised its key interest rate from 8.5 to 45 percent between May 2023 and early 2024. This occurred in response to the lira's multi-year depreciation, which, while not stopped, was slowed. Brazil also demonstrated the effectiveness of high interest rates; the key interest rate temporarily reached 13.75 percent in 2023, attracting carry trades and strengthening the real. Mathias Beil notes that the effect of interest rates primarily works through the differential to other markets. An additional return of five or ten percentage points can justify a currency risk under certain conditions, provided the market has confidence.
However, this textbook logic has its limits, as Japan illustrates. In March 2024, the Bank of Japan raised its key interest rate for the first time in 17 years from minus 0.1 to 0.1 percent, yet the yen continued to depreciate. The reason for this was the still significant interest rate differential to the US, where interest rates were about five percentage points higher. Only in July 2024, when the Bank of Japan raised rates again and interest rate cuts in the US became foreseeable, did carry trades unwind, and the yen gained almost 15 percent within a few weeks. Beil emphasises that it was not the interest rate hike alone that was decisive, but the expectation regarding future interest rate differentials. Great Britain experienced a different kind of limitation in 2022: although the Bank of England raised its key interest rate from 1.75 to 5.25 percent between August 2022 and August 2023, the pound sterling came under pressure. The so-called mini-budget by Liz Truss's government, with unfunded tax cuts, triggered doubts about public finances, led to capital outflows, and higher interest rates could not compensate for this loss of confidence.
Mathias Beil concludes that the exchange rate of a currency is ultimately also a price of confidence. When doubts grow about politics, public finances, or economic stability, higher interest rates are not necessarily sufficient, as investors then not only demand more return but also reduce their overall risk. For investors, this means that interest rate differentials remain an important indicator but should not be considered in isolation. Capital flows, fiscal policy, and political risks are equally crucial. In addition, the positioning of major market participants plays a role. According to Beil, interest rates alone have no power but can only exert it in combination with a high degree of confidence and minimal geopolitical interference. Beil summarises that there has recently been little confidence and a lot of interference.
