Fri 28th September 2012
If the Bank of England were to raise interest rates, the pound would likely climb against the US dollar. This is because of the effect on UK bonds and equities from an interest rate rise, and their attractiveness to investors.
If the Bank of England raises interest rates, it has a direct effect on the rate of return investors can expect from UK government bonds. In short, the return goes up. That therefore makes these bonds more attractive.
Now, since in order to purchase these bonds investors must first purchase UK pounds, an increase in the rate of return on UK bonds drives up demand for the pound. That increases its value.
Hence, in this way, if the Bank of England were to raise interest rates, the pound would climb against the US dollar.
Real life example
For a real life example of the effect of interest rates on a currency, we can look to Australia.
Today, Australia has one of the highest benchmark interest rates in the world among the industrialised nations, at 3.5%. It’s also one of only seven countries to boast a AAA credit rating. Given that, its government bonds are highly attractive to investors.
This explains why, since 2008, the Australian dollar has climbed and climbed against a basket of currencies, including the pound, US dollar, and euro. Australian government bonds simply offer a better proposition than most others, sending the AU dollar sky-high.
Other foreign exchange influences
However, it’s worth pointing out that, just because the Bank of England raises interest rates, does not guarantee the pound will climb. The example I gave above just outlines the normal correlation between interest rates the foreign exchange.
In reality, there are always several influences on the exchange rates at any one time, which could offset the impact of a rise in interest rates.
For instance, were the Eurozone to announce full-blown integration, and the creation of a United States of Europe, we could expect that to take precedence over an interest rate rise.
In that instance, the pound might not climb against the US dollar, because the markets are more concerned about events in Europe than the UK. Of course, this is an extreme example, but it illustrates my point.
Find out more
I do hope you’ve enjoyed reading this post. To find out more:
Read our Daily Market Commentary to find out what’s affecting the rates today.
Take a look at our Foreign Currency Exchange Advice articles.
Look through our Top Tips to maximise your foreign currency transfer.