Understanding Interest Rate Differentials

Various paper currencies
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If you have been thinking about investing in foreign money, you should know about interest rate differentials (IRD). An IRD is a change in the interest rates between the currencies of two countries. It is a measure of how money from two countries compares to each other. For instance, if one currency has an interest rate of 3% and the other has a rate of 1%, it has a 2% IRD. The use of IRDs is a vital concern and interest in foreign exchange (forex) markets for pricing reasons.

If you were to buy the currency that pays 3% against one that pays 1%, you would be paid on the difference with daily interest payments. This is known as the carry trade. You're earning carry on the IRD. Economic changes in the 2010s, such as negative interest rates, have caused more people to look into and learn more about IRDs. A person who lives in a county where the rates are at 0% or lower can decide to exchange money to the currency of some other country where the rates are higher. That person could then invest that money and try to earn a higher return.

Key Takeaways

  • An IRD is the spread in the interest rate between the currencies of two countries in foreign exchange markets.
  • The carry trade is what happens when you buy currency that has a higher interest rate against currency with low or no interest and receive payments for the difference.
  • Starting in 2014, developed markets took their interest rates below zero while emerging market currencies raised their interest rates.
  • Forex traders look to make the most of the ​negative interest rate policy with the carry trade, but this tactic can be risky for new investors.

Negative Interest Rate Policy (NIRP)

Starting in 2014, experts began seeing a wide gap between the interest rates in developed markets versus those in emerging markets. Developed economies took their rates below zero to try and spur demand. At the same time, newer markets raised their rates to limit capital outflow and to head off economic instability. In February 2016, for instance, the Bank of Mexico (Banxico) held an urgent meeting to raise its borrowing rate by 50 basis points while selling U.S. dollars at the market rate to spur demand for the falling Mexican peso.

While this action taken by the country widened the interest rate span between the U.S. and Mexico, it was also taken by the market as a sign of weakness by central banks to prevent the global economy from spinning out of control.

The Carry Trade

Forex traders are focused on making the most of the ​negative interest rate policy with the carry trade. They do this by selling euros or Japanese yen (or any currency with negative rates) and buying emerging market currencies such as that of the Indian rupee or Turkish lira. Investors may use the carry trade to borrow money at a low rate and then use the money they borrow to invest in assets or securities that offer a higher rate. These trades, which on paper have very large IRDs, could easily end up being risky if the exchange rate has a big change. This is even more true if the economic ups and downs found in emerging markets linger or become more severe.

While the carry trade does earn interest on the IRD, the gap in the currency pair spread could narrow or go away. This has been known to happen in the past. If it does happen, it could wipe out the benefits of the carry trade.

Forex Traders Proceed With Care

The old saying, "Too much of a good may not be good," can apply to IRDs. In other words, when the rates widen too much, they have done so because the risk is seen as a threat to the borrowers in those countries. The large gap may seem like a good way to make money, but it can also signal trouble.

If you are a new forex trader who has just heard about the carry trade and are thinking about jumping in, proceed with caution. You may see negative interest rate currencies that look like they would be good for selling or emerging market currencies that look like surefire buying currencies. You need to look deeper into the reasons for both. For instance, in the past few years, frequent turmoil in commodities and concern stemming from trade disputes between China and the U.S. have been putting pressure on currencies offering a higher yield.

At the same time, the debut of negative rates, as well as qualms about other money policies such as quantitive easing, are driving some people to direct their money to haven assets. These assets that often have the lowest rates. Still, they don't lose value during economic hard times, and they may even gain value.