How Does Negative Interest Rate Affect Currency Prices

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Interest rates in countries around the world have dropped to the lowest levels ever in history following the financial crisis that was witnessed during the years 2008 and 2009. As the recovery was very sluggish, many economies could not recover as envisaged and attain normalcy immediately in the subsequent years. The recovery continued, but the fresh waves of economic weakness that were experienced in 2016 were instrumental in exerting more downward pressure and driving the interest rates further down. They even pushed the interest rates in some countries into negative territory for the very first time.

How Does Negative Interest Rate Affect Currency PricesPreviously, many economists were of the opinion that the zero percent interest rate cannot be breached at all. Contrary to their beliefs and expectations, interest rates have hovered around in the negative territory in countries like Japan, Germany, Denmark, Sweden and Switzerland for several months now and it is expected that it will remain negative for some more time to come. Interest rates became negative in these economies following the depreciation of their domestic currencies against the US dollar. This is to say that the yen, euro, krone, franc and krona lost value against the USD and GBP during the period from August 2015 to August 2016. During this period, the Japanese yen fell by as much as 18 percent against the US dollar.

Historically, the devaluation of currencies has always led to a fall in the interest rates. Japan and Europe have faced the threat of deflation because of a weakening of the demand. This in turn forced the central banks in these countries to implement unprecedented monetary policy measures for the purpose of creating inflation and stimulating investment. However, inflation has come in below even analysts’ expectations at times because of the availability of excess capacity in all of these countries. As a result of this, banks, consumers, corporates and investors have remained conservative and this in turn has dampened the effects that are typically associated with easy monetary policy regimes.

Currencies and Interest Rates

Expansionary monetary policy helps to enhance a country’s economic growth and aggregate demand. It involves increasing the money supply or cutting down interest rates in order to boost economic activities within the country. Central banks resort to expansionary monetary policy with a view to combat recessionary trend, hesitant business investment or poor consumer sentiment. Many a time this is implemented by increasing the money supply within the country. The Federal Reserve’s most preferred way of raising money supply is by involving in open market operations. In this method, the Federal Reserve buys/sells securities for the purpose of changing the level of reserve balances available within the banking system. When the money supply improves, interest rates fall and the quantity demanded rises. This in turn stimulates consumer spending, business investment, supports higher employment and payment of better wages.

The raising of the money supply by a central bank causes devaluation of the country’s currency with respect to other currencies in the world. A fall in interest rates that ensues leads to a drop in global demand for the securities that are denominated in the domestic currency. This makes the country’s exports to be less expensive. This is, of course, on the assumption that the prices remain sticky. This brings in a beneficial kind of situation to economies that export a great deal of goods and services. On the other hand, devaluation causes the goods and services imported from other countries to become more expensive.

China resorted to a significant devaluation of its currency in the years 2015 and in 2016. According to observers, the reason for the devaluation of yuan was to stimulate export. On the other hand, some people, including American president elect Donald Trump, accused China of involving in unfair trade practices. They cited the degree of devaluation, which was by all means extreme. The devaluation coincided with the situation prevailing in the country that made it difficult for the government to achieve the projected growth. Manufacturing and exporting sectors were severely affected. However, some other economists pointed out that the reason for devaluation was the influence of the charge of the U.S. dollar on the yuan. This, according to them, pulled the yuan in a not-so-favorable direction with respect to the nation’s some of the other big trading partners. Following this, the People’s Bank of China has cut the benchmark interest rate from 6 percent in late 2014 to 4.4 percent by 2016. This is an example as to how currency devaluation impacts interest rates.

Negative Rates

Negative rates can be categorized as a peculiar situation. This is because the basic logic that governs the lending decisions are violated in such a situation. If the interest rate is negative, it indicates that the entity providing credit is losing capital by taking the counterparty’s risk. However, the central banks in many countries have been in a position to implement negative real rates because of the continued demand from investors for low-risk securities as result of the prevailing uncertainities and poor returns provided by other asset classes.

Actually, the economic growth will not be stimulated if investors just rush to low-risk assets. The reason as to why the interest rate is taken to the negative territory by the central banks is to spur economic growth. Consumers, businesses and banks that hoard cash get punished when the interest rate becomes negative if they do not respond in the right way.

In Germany, Japan, Denmark, Switzerland and Sweden, the savings rates have been increased in spite of the fact that the lending rates have been kept negative for a few months now. However, business investment has remained below expectations. Further, the inflation has been rising rather slowly in Japan and Europe because of the high unemployment rate prevailing in these countries. Moreover, industrial capacity utilization has been very low. All these can be related to the fact that the currencies of these currencies have depreciated with respect not only the US dollar, but also other world currencies.

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