Interest rates and exchange rate variations: Understand their relationship and impacts
Interest rates and exchange rate variations: Grasp what these two concepts are, what the relationship between them is, and how they impact commodity markets.
You may have already heard in the news that the prime interest rate in the United States has risen, which has in turn caused exchange rate variations in global financial markets. But what does this mean in practice for those working in the commodities sector?
To clarify these two critical concepts that are part and parcel of the daily lives of traders, we invited Alef Dias and Victor Arduin, Market Intelligence Analysts at hEDGEpoint, to explain:
- What is the prime interest rate?
- What are the exchange rate and exchange rate variations?
- How are interest rates and exchange rate variation associated?
- What are the main impacts on commodity markets?
- A current example to understand this peculiar relationship.
- How important is hedging in this context?
Keep reading to find out more!
What are interest rates?
In general, interest is an economic index used to record the profitability of an investment or the cost of money over time. Interest plays an important role in economies: it helps regulate the flow of money, encourage investment, and control inflation.
“The interest rate is one of the main factors that influences the value of a currency. When a country increases its interest rates, its currency tends to appreciate against others,” Alef Dias explains.
Thus, interest rates relate to the amounts paid or received at the end of a pre-agreed period. In commodity markets, they´re especially important because the prices of futures contracts and other derivatives, as they´re businesses that depend on future settlement, are greatly influenced by global interest rates.
Among them, the overnight financing rate, or SOFR (an acronym meaning Secured Overnight Financing Rate), stands out as a particularly influential interest rate that banks use to price derivatives and loans denominated in dollars.
This is the main reference used to signal the profitability of securities based on variable rates, which mainly reflect the rates applied to daily U.S. Treasury repurchase transactions.
What are the exchange rate and exchange rate variation?
Exchange rate variation is different from the exchange rate itself. Let’s consider the variation in the U.S. dollar: it´s linked to the concept of supply and demand. If there´s a large supply of dollars available in the country, the U.S. currency ends up being devalued.
On the other hand, if there´s a lower supply, the currency appreciates. The price paid for the dollar in this case is called the exchange rate, reflecting the relative price of one currency related to another. The exchange rate variation then is the exact difference between the two exchange rates (the one used by the business on the date of purchase, and the one that will be applied on the day of payment).
”Exchange rates highlight the differences in the prices of money in different economies. For example, if you have a more expensive dollar, it gets stronger in relation to the real,” Dias elaborated.
Exchange rate variation occurs due to the devaluation or appreciation of one currency related to another, which affects the prices of imported and exported goods. As commodities are traded worldwide, and gain their reference prices set in different currencies, the price difference is essential for buyers and sellers.
For example, if the Brazilian real appreciates related to the dollar, this can negatively affect the revenue of an exporting company that trades in dollars. The appreciation of the dollar against the real can lead to significant increases in agricultural production costs, as many inputs are priced in dollars in international markets.
How are the interest rate and exchange rate variation related?
The interest rate influences exchange rate variation. For us to understand better, let’s turn to the U.S. and the commodity of oil. If the country raises interest rates, this means that liquidity is reduced in the domestic market. What´s one of the major effects of this action? Appreciation of the dollar happens, and there are possible consequences for global oil prices.
“Oil is priced in dollars in international markets. So, when the dollar strengthens in relation to the real, oil prices tend to rise in Brazilian reais, making it more expensive for the Brazilian consumer,” Arduin clarified.
As a result, demand for the dollar grows, leading to further appreciation of this currency in relation to other economies. In this way, if a certain country decides to increase its interest rates, it becomes more attractive for foreign traders to trade there. This is because they can earn a higher return on their trades in relation to the interest, which increases over time through the appreciation of money.
In this scenario, exchange rate appreciation may also occur. That is, the government could adopt measures that aim to value the local currency in relation to other international currencies. This is what happens if you pay too much for oil when it´s imported.
Commodity Markets: The impacts of interest rates and exchange rate variation
To help you understand how interest rates and exchange rate variations impact the commodities sector, Alef Dias gives the grain market as an example.
“Imagine that the U.S. increases its interest rates. Brazil, in turn, reduces its interest rates. The dollar strengthens in this situation. If the Brazilian real depreciates, then Brazilian soybeans become cheaper. Thus, Brazil tends to export more,” Alef added.
The big risk of rising interest rates in economies like that of North America is the possibility of a global recession. In commodity markets, this situation can result in lower demand for products, as in the case of oil.
“The increase in interest rates increases the value of the dollar and has the chance of reducing economic activity, which leads people and companies to spend less, encouraging the use of financial investments. Hence, the demand for commodities is impacted, generating volatility due to price changes,” Arduin continued.
An example to grasp the relationship: The U.S. and interest rate increases.
The Fed (the abbreviation for the Federal Reserve, which is the de facto central bank in the U.S.) announced that the prime interest rate has recently been maintained, with the possibility of a new spike before the end of the year. The process of raising interest rates began in March 2022, and has reached the expressive number of between 5.25% and 5.5% per year.
“The U.S. is experiencing very high inflation, and the increase in the interest rates is a response to this. The Fed in North America wants to converge prices towards a 2% inflation target, without harming the economy. However, this kind of interest rate increase over a prolonged period has repercussions on commodity markets, with possible drops in the values of products coming from emerging economies,” Arduin said.
Higher interest rates in the U.S. can negatively affect global economic growth as rising borrowing costs discourage consumption and investment. A global economic slowdown could lead to a decrease in the demand for commodities, which in turn puts downward pressure on prices.
When interest rates rise in the U.S., international capital tends to move there. The fact that the trader earns more with less risk makes other markets less attractive, as in the case of emerging economies, forcing them to improve their risk premiums and increase interest rates.
“As the currency of these emerging economies depreciates, it becomes more advantageous for producers to export. However, macroeconomic impacts tend to stand out in these nations. With rising interest rates and global inflationary pressure, economic activity tends to retract. Investors withdraw resources from emerging countries to invest in the U.S., with adverse consequences for the currencies of emerging economies,” Dias added.
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What´s the role of hedging in this context?
Fluctuating interest rates and the resulting exchange rate variation are factors that influence investment and consumption decisions on the planet, affecting commodity supply and demand.
It´s vital for traders to protect themselves from price volatility by using hedging tools to better manage risk. hEDGEpoint offers such hedging instruments, combined with extensive data analysis and insight, for everyone involved in these markets.
Talk to us today and find out how we can help your business!
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