Can someone please explain the relationship between interest rates, inflation and currency value?

Been studying up for a S&T interview and this is driving me crazy.

(1) Inflation vs. Currency Value: Negative Correlation

The relationship between inflation and currency value is by far the most straight forward in my opinion. Inflation decreases the value of currency in purchasing goods, which drives down the currency's worth relative to other currencies. Please let me know if I'm wrong on this. 

(2) The relationship between inflation and interest rates is making little sense to me.

(a) Positive Correlation: On one hand, high inflation causes investors to demand a higher yield on their bonds to compensate. Additionally, higher inflation would cause the prices of the goods that companies sell to increase, reflecting positively in earnings and resulting in faster growth for companies, thus driving down demand for bonds -> lower bond prices -> higher interest rates.

(b) Negative Correlation: On the other hand, Investopedia says that 

  • In general, when interest rates are low, the economy grows and inflation increases.
  • Conversely, when interest rates are high, the economy slows and inflation decreases.

Above are evidenced by the fact that the Federal Reserve uses higher interest rates to discourage spending and thus decrease inflation during periods of rapid expansion, and lower interest rates to encourage spending and increase inflation during periods of contraction. What gives? Which one is right?

(3) Interest Rates vs. Currency Value: Positive Correlation

All I know about this one is that its for some reason accepted that higher interest rates tend to attract foreign investment, which requires demand for the country's currency, thus higher interest rates beget higher currency value. But at the same time, wouldn't higher interest rates constrain the rate at which companies are able to expand, thus reducing foreign investment in equity markets? Wtf?

Would really appreciate some opinions from those more knowledgeable than I am.

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Comments (7)

  • Intern in S&T - FI
Feb 23, 2021 - 10:21pm

Good job with your research, but what helped me was making everything as simple as possible.

Example: you borrow $1000 from country A for a year loan. You can either:

1) invest in country A's rates for a year

2) exchange for country B's currency and invest in their rate, then transfer back.

In an "efficient market", these two returns would be equal (this is seen in futures pricing). If a country has/expects higher inflation they will raise rates to maintain this equilibrium as inflation devalues a currency in comparison to other currencies. Another good thing to research is the difference between a futures price being higher or lower than the spot price and why that is. 

Disclaimer: this is all theoretical and works perfectly in academic cases but not always in practice, but happy to answer any follow up questions

  • Intern in S&T - FI
Feb 23, 2021 - 10:26pm

To address question 3), higher interest rates bring foreign investment which means the foreign currency is in high demand=> strengthening currency. To complete this cycle though, increasing demand for bonds => lower rates because of price vs rate relation.

Most Helpful
  • Intern in Consulting
Feb 24, 2021 - 1:34am

So I think you need to frame your thinking differently. Three things: 1) I think you shouldn't look at these as 'correlations'. As you say many times in your post, these are causations (i.e, A->B, like in philosophy class), 2) since interest rates are a key lever for central banks, you mainly should look as interest rates as the independent variable (i.e, the "A" in A->B), 3) if you've taken a logic class, you know that A->B = !B ->!A (the contrapositive). This is also logical in explaining these causations. I'll try to explain through an example through 2 since you're confused there: 

So here, let A be interest rates, B be inflation. The generally accepted relationship is that as interest rates go up -> inflation goes down & as interest rates go down -> inflation goes up. This squares with the Investopedia 2(b) explanation and makes sense because if rates go up, then people are less incentivized to borrow and therefore spend less on goods and services. This reduces inflation because the price level of G&S does not rise due to increased demand - vice versa if rates go down.

Now to look at the contrapositive. !B (inflation goes up) -> !A (interest rates go down). High inflation means the central bank probably wants to slow that down, so they cut rates (!A).

Like the previous comment said, there is no 'set in stone' relationship between these variables, though there are popular ones. For example, like I said, it's pretty well-known that the market will reflect higher inflation if rates are cut. However, in the contrapositive case, it gets a little murky. As in your 2(a), higher inflation could lead to investors demanding a higher rate, but it could also lead to the central bank reducing inflation by increasing rates and therefore precluding investors from demanding that higher rate. Having interned at a BB trading floor, what matters is not that you memorize the relationships, but that you're able to explain step-by-step how you hypothesize these things would work. Hope this helps!

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  • VP in S&T - FI
Feb 24, 2021 - 8:28pm

If i asked this in an interview, I'd be looking for a simple answer, since the real world is nuanced and it doesn't always hold, and the academic views have been wrong for decades.

in general in developed markets, when inflation goes up, it causes rates to go up, and the currency appreciates. You earn more carry which makes the currency more attractive to be long. Higher rates also tend to attract inflows, which increases the fx.

many strategies are built on following the interest rate differentials, not that it performs too well, but that's the basic logic 

  • VP in S&T - FI
Feb 24, 2021 - 9:12pm

Delectus nemo qui et ullam quo quis. Et sint perferendis modi laborum modi. Rem ullam et sunt nulla debitis.

Possimus facere earum quis laborum iste aperiam architecto cupiditate. Dolorem esse quis modi quia ab rerum. Id ut ullam vel repudiandae incidunt.

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