In the Worldwide Race to 0%, Do Interest Rates Even Matter Anymore?

We used to have a glut of high interest rates throughout the world. In fact, an industrious, profit-seeking Forex trader could find higher returns than the dollar almost anywhere from the high-yielding euro to the Aussie dollar…from the British pound to even the Mexican peso for a while.

But of course, today it’s a whole other story.

As you know, central banks around the globe are sitting on some of the lowest rates in history. Every month, we hear that yet another central bank has decided to follow the rate-cutting herd and slash off another half or quarter percent. And many countries – including the U.S. – already have effective interest rates of 0%.

So here’s a question: In the race to 0% interest rates – should Forex traders even watch interest rates anymore? Do they still have any bearing on currency investments?

The short answer: Yes, they still do.

The slightly longer answer: Interest rates still matter; just not as far as carry trading is concerned. (Recall carry trading involves using a low-yielding currency to buy a high-yielding one and earn the difference between the two.)

The Key to the Most Influential Forex Trade of the Decade

For years, carry trading was a globalized game of skill where you could “borrow” at near 0% and then reinvest those assets into a higher-yielding currency so you could collect a profit as high as 7% to 8%. It was a fairly foolproof game until the credit crunch stole all the fun.

During these years of milk and honey for the markets, traders chased after the highest yields. So if your currency was high and likely heading higher, then traders dumped money into it…and that just pushed it higher.

Therefore these traders earned not only the spread between the two interest rates but they also made money on the appreciation. The perfect carry trade has a higher-yielding currency that appreciates, while the lower yielding currency depreciates.

However, the credit crunch literally stopped and reversed this process as these carry traders had to do what the market calls “unwind their carry trades.” This means they simply had to pay back their loans (and thus the traders had to close out their positions).

So if you originally sold a low-yielding currency and bought a high-yielding currency, now in order to close that trade out, you had to sell the higher yielding one and buy back the lower yielding currency. By the way, this is where the dollar and yen rallies have come from in this past year.)
These Two Currencies Will Recover First

If there aren’t any major currencies out there now with “whopping yields” as before, then why do interest rates still matter?

In short, they matter because if central banks signal that they are going to stop cutting rates and possibly even consider raising them again, then it eventually starts this carry trading game back up again.

Should this happen, the first major currencies to benefit from it will likely be the New Zealand and Aussie dollars. Why? Because they have the highest yields out there of any industrialized nation. The New Zealand dollar currently has an interest rate of 3% and the Aussie has a rate of 3.25%.

This is about six times more interest than most other major currencies around the world. Even the euro is only at 1.50% right now. Many currencies are at 0.10% to 0.50%. So it will be a while before they are even worth investing in from a carry trade (interest bearing) perspective anyway.

After new up trends are firmly established in stocks and commodities once again, then you should see emerging currencies start to benefit once again as well. (In fact, they have even larger interest rate yields than that of the Aussie and Kiwi dollars put together!)

Best Regards,
Sean