The real interest rate differential model

The real interest rate differential model suggests that in currency price movements are determined by countries' interest rate levels. So, countries with high interest rates should experience an increase in the value of their currency, while the reverse should occur in countries with low interest rates.

As we will see below, this model isn't able to explain each movement in the currency exchange market, although much of what is happening in forex (and in other financial markets) is directly and indirectly linked to interest rates.

Basis of the model

Whenever a country raises its interest rates, international investors discover that its currency has a higher yield and they start to buy it. This theory worked very well in 2003, when interest rate spreads were fairly close to the highest levels observed in recent years.

During this year, the interest rate data for the major economies was as follows:

Interest rates in 2003

According to the data in the above chart, the Australian dollar had the highest base point spread as well as the highest returns against the US dollar, which certainly supports the model, since the international investors had massively bought the Australian currency. The same goes for the New Zealand dollar, which also outperformed the US dollar by 27%. However, the model was imprecise in relation to the euro, which had experienced the strongest rise against the American currency, with the exception of the NZD, despite its spread of 100 basis points. The model raises even more questions when comparing the Japanese yen and the British pound. In the case of the yen, the spread was -100, but it had increased by almost 12% against the dollar. As for the British pound, it had only increased its value by 11% against the dollar, while it had an extremely high interest rate of 275 points.

The model also says that one of the fundamental factors that determines the level of reaction of the change in the price of a currency to a change in interest rates is the expected duration or persistence of this change. Thus, if an interest rate hike is expected to last five years, the effect on the currency exchange rate will be much greater if one expects the hike to only last a year or two.

Limits of the interest rate differential model

International economists are currently questioning the existence of a real and truly significant relationship between changes in a country's interest rates and its currency exchange rate. The main weakness of this theory is that it doesn't take into account the current account balance and that it is based solely on capital flows.

Even this model tends to over-represent capital flows to the detriment of other factors which also affect a currency's exchange rate, such as inflation, political stability, economic growth and others. In the absence of other factors such as those mentioned above, this model can be useful, since it makes sense to conclude that a trader will direct his capital towards the investment assets that offer the best returns.

In fact, any announcement linked to changes in a country's interest rates, especially in the case of major economies, can lead to lively markets, especially those that are linked to the currency in which there could be an interest rate increase or decrease. A clear example are the FOMC meetings, in which the market is kept waiting for any indication that the United States could change rates or leave them unchanged.

In conclusion, despite the fact that interest rates and differentials between countries cannot explain every forex movement, it is a fact that in the long run - and even in the short term - much of what is going on in this market is specifically due to interest rates and the variations that occur there, especially in comparison to other countries.

Summary - Interest rate forecasts according to economists