Why does increase in interest rates lead to currency appreciation?

An increase in interest rates often leads to currency appreciation due to several economic dynamics:

1. Attractiveness of Higher Returns

• Higher Interest Rates = Higher Returns: When a country's central bank raises interest rates, it offers higher returns on investments denominated in that currency. This makes the country more attractive to foreign investors seeking better returns on bonds, savings accounts, and other interest-sensitive assets.
• Increased Demand for Currency: To take advantage of these higher returns, investors need to buy the local currency. This increased demand for the currency leads to its appreciation relative to other currencies.

2. Capital Inflows

• Foreign Investment: Higher interest rates can attract foreign capital in the form of investments in financial markets, real estate, or direct business investments. As foreign investors convert their home currency into the local currency to invest, it drives up the value of the local currency.
• Portfolio Investments: Investors may shift their portfolios towards assets in the higher-interest-rate country, leading to increased demand for that country's currency, further boosting its value.

3. Inflation Control

• Interest Rates and Inflation: Central banks often raise interest rates to control inflation. Higher interest rates can reduce spending and borrowing, slowing down economic activity and reducing inflationary pressures. Lower inflation generally leads to a stronger currency because it preserves the currency's purchasing power.
• Investor Confidence: A country with controlled inflation and a stable economy is seen as less risky, making its currency more attractive to investors. This confidence can lead to further appreciation of the currency.

4. Speculative Activity - Currency Speculation:

• Traders and speculators may anticipate that higher interest rates will lead to currency appreciation and, as a result, buy the currency in advance. This speculative demand can contribute to the currency's rise in value.
• Short-Term Gains: Even short-term traders may move capital into higher-interest-rate currencies to take advantage of quick gains, driving up the currency's value temporarily.

5. Exchange Rate Expectations

• Future Expectations: If markets expect that interest rates will continue to rise or remain high, they may anticipate further currency appreciation. This expectation can lead to more demand for the currency in the present, pushing its value higher.
• Forward Rates: Expectations about future interest rates influence forward exchange rates, which in turn can impact the current spot exchange rate as market participants adjust their positions.

Summary

In summary, an increase in interest rates typically leads to currency appreciation because higher interest rates attract foreign investment, increase demand for the currency, help control inflation, and boost investor confidence. This combination of factors drives up the currency's value relative to other currencies.