The first one which we are all aware of, and affects us directly are interest rates. The central banks of most developed countries use interest rates as a blunt instrument with which to control both inflation, and the broader economy. From a trading or investing perspective interest rate policy is a key driver of currency prices. In simple terms if a country decides to raise it’s interest rates, then the currency of that country will strengthen, since the higher rates will attract more foreign visitors. So taking the example of a European resident invested in euros, if they decided to invest in US treasuries, then they must sell euros and buy dollars in order to purchase the bonds. If you believe that interest rates in the US will rise in the longer term, then you are confirming your belief by opening a long position in the US dollars.

If your view is that the US Fed is unlikely to raise US rates further, then you could back this view by buying a currency or assets in a country with a higher rate, or one where you believe higher rates are likely to follow in the short to medium term. If for example you believe that rates may fall in the US, but rise in the Eurozone, then for the euro vs dollar, this could drive investors to buy euros and sell US dollars. Interest rates also create differentials between countries which allow speculators to profit from the carry trade. The currency speculator borrows money in a low interest rate country, and then buys assets in a country with a higher yielding interest rate, generally investing in assets such as bonds, resulting in significant flows of money from the low interest country to the higher. The carry trade appeals because of the returns available, particularly if invested in bonds. Many countries with low interest rates suffer from currency speculation, which in turn affects the strength or weakness of the currency. The euro vs dollar is less significant in this respect since the differential is relatively small at present.

(C) The Financial Times 2010