How interest rates and inflation affect the value of currencies and exchange rates

At some point, every expat will need to move money abroad, whether it's to buy a property, make an investment, receive income, or send money home to friends and family.

Therefore, understanding how ever-changing factors such as interest rates and inflation impact currency values is essential for managing your finances in the short and long-term. 

We spoke to Max Huseyin of Moneycorp to find out what expats need to know about how interest rates and inflation affect currencies and exchange rates.

Watch Max's video interview here, or read the summary below:

How do interest rates and inflation affect the value of currencies?

At present, we're in a bit of a bubble when it comes to inflation and interest rates. This started back in 2023, when we first saw Russia go to war against the Ukraine. That led to the cost-of-living crisis, increased energy prices, and increased inflation and interest rates that we're seeing today.

Let’s start with the fundamentals on interest rates. Higher interest rates attract foreign capital due to better returns on investments in that currency. Then, as more investors seek these higher returns, the demand for that currency increases. This leads to an appreciation of the currency's value.

Lower interest rates lead to the reverse. Because lower interest rates offer less attractive returns, this discourages foreign investment. With less foreign capital inflow demand for a currency decreases, leading to a depreciation of the currency's value.

Now let’s look at inflation. Higher inflation leads to reduced purchasing power, eroding the power of a currency and making it less valuable. In turn, this decreases the confidence across markets leading to potential sell off in that currency. This then leads to a depreciation in the currency and its value will fall.

In an economy with lower inflation, the purchasing power of that currency is maintained. Lower inflation increases confidence, with the predictable value of the currency leading to increased demand, which in turn leads to currency appreciation.

In summary, high interest rates and low inflation are positive for a currency whereas low interest rates and high inflation mean currency weakness.

When you’re looking at how interest rates and inflation might impact the value of currency, you also need to consider market sentiment. Expectations of future changes of interest rates and inflation will impact the value of the currency and can be priced into the market.

Which currencies have the biggest global impact when it comes to those currency fluctuations?

There are several countries which have the most significant impact on currency fluctuations, and multiple factors contribute to their global impact including:

• The size and importance their economies
• The volume of their trade
• The influence of their financial markets

Currencies are often referred to as either major or reserve currencies, so let’s talk through the primary ones:

United States (USD)

The US dollar is the world's primary reserve currency. USD is widely used in international trade and held by many of the world's leading and emerging central banks. The US is also the largest economy in the world. From an interest rate policy perspective, decisions by the Federal Reserve on interest rates and monetary policy have far reaching effects on global markets

Eurozone (EUR)

The Euro is the second reserve currency. It's the second most held currency across the world and has a significant economic bloc. The Eurozone compromises multiple influential economies like Germany, France and Italy and makes up a huge part of the world's GDP. Policies and interest rate decisions by the European Central Bank can significantly impact global markets in the same way as the US.

United Kingdom (GBP)

The UK is considered the financial hub of the globe. It’s one of the world's leading financial centres and holds significant economic influence. Policies from the Bank of England are watched closely by global investors. And, as we all know, events related to Brexit have caused significant fluctuations in the value of the pound over recent years.

China (CNY)

China is the second largest economy in the world and its trade influence as a global exporter significantly impacts global currency markets. The People's Bank of China monitor the value of their currency very closely and interject when applicable.

Japan (JPY)

The Japanese Yen is considered a ‘safe haven’ currency, often sought during times of global uncertainty – it is particularly strong right now. Japan holds significant economic influence with the third largest economy in the world and, from a monetary policy perspective, the Bank of Japan's policies differ from what we've seen in the UK, the US and the Eurozone. They've introduced unconventional measures like negative exchange rates and negative interest rates, which can impact the global currency markets. Japan also actively manipulates their currency to set it a level they're comfortable with.

Other notable currencies

• The Canadian dollar (CAD) and the Australian dollar (AUD) are commodity currencies (i.e. highly correlated to changes in the prices of the commodities they export)
• The Swiss Franc (CHF) is also considered a ‘safe haven’ currency during times of uncertainty
• BRICS nation currencies (Brazil, Russia, India, China and South Africa) are also gaining more importance as their economies grow and integrate more deeply into the global economy

How expats can mitigate the impact of currency fluctuations in the short and long term

Whether you’re selling a property, moving investment or future proofing your wealth, if there's an international element to a transaction, currency fluctuations will have an impact. However, when you’re also focused on tax implications, legal guidance and financial advice, foreign exchange and international payments can easily be overlooked as a consideration.

The easiest way to mitigate risk associated with moving money internationally is to understand the risks and what tools are available to protect you against – or take advantage of – favourable or unfavourable foreign exchange movements.

The best way to do this is always to speak to an expert. For example, our partner Moneycorp, specialises in foreign exchange and international payments. Ultimately, every client requirement is unique – there's no one size fits all model so they focus on understanding what their clients need to do, the reasons they need to do it, and what timescale they need to operate within, so they can present them with the appropriate solution.

Tools we use to help our clients protect themselves against currency fluctuations include:

Spot contracts

A spot contract is a buy now, pay now contract. If you've got a payment that needs to be made instantly, you would use a spot payment to convert from one currency to another then make your payment the same day or next day.

Forward contracts

If you need to protect yourself against longer term currency volatility, a forward contract gives you the ability to secure an exchange rate today for a date in the future, giving you certainty of the rate you will get when it comes to the transaction. Forward contracts are used a lot in property purchases.

As an example of how spot contracts and forward contracts work together, if you’re an expat living in the UK and your wealth is based Europe, you would use a spot contract to manage the deposit payment for the property purchase. You’d then use a forward contract to secure the exchange rate for the completion part of the property purchase for up to two years.

Market Orders / Rate Watches

These tools enable you to be notified when a particular rate you’re looking for becomes available, or execute an agreement to buy that rate as soon as it becomes available via our banking network.

Why is it so important for expats to understand how currencies are affected by interest rates and inflation?

Without understanding how currency fluctuations can impact your personal wealth and finances, you won’t know how to protect against them.

Many expats earn income in one currency and incur expenses in another, meaning fluctuations in exchange rates can significantly impact their purchasing power and cost of living. A lot of expats will also send money back home, which means understanding currency dynamics helps them choose the best times for remittances, ensuring more value is being transferred to family members back home.

Currency fluctuation can also impact the value of your investments as an expat. For example, a strong home currency can devalue foreign investments when converted back, so this is something you need to consider when making investment decisions and managing international investments.

Interest rates also influence the return on your savings. Therefore, you need to understand where your money is going to work best for you including which country's banking system offers the best rates and how inflation might erode any returns.

There are a number of hedging strategies and solutions we can offer to protect you against adverse currency movements, but by understanding the risks for yourself, you can make the decision to diversify your investments and savings and reduce exposure across any one single currency.

Looking further ahead to retirement and long-term financial goals, currency fluctuations will also have an impact of the value of your pension and retirement savings. On a monthly basis, your pension could be worth more or less depending on what exchange rate is available. Understanding these dynamics is essential in the long term.

In summary, understanding the interplay between interest rates, inflation and currency values is essential for effective financial management for expats. Currency fluctuations can impact day-to-day financial decisions, long-term investment strategies and overall economic well-being. By staying informed, expats can better navigate the financial complexities of living and working abroad, ensuring greater financial stability and security.

Always seek advice from a currency specialist

As with any financial decisions, we recommend all expats seek guidance from a currency specialist. There have been some significant changes in the currency landscape over the last few years which have had an impact on expats’ wealth, and with expectations that interest rates are likely to fall around the world, the knock on effect of these changes could have a significant effect on the value of any international money transfers.

With expert guidance, you’ll know you're on the right path to making the best decisions when it comes to international money movement.

At Experts for Expats we can introduce you to one of our trusted currency exchange partners who will be able to discuss your requirements and plans to help you cost effectively navigate the complex world of currencies and foreign exchange.

Request your free introduction to one of our currency exchange partners >