For businesses that import, export or operate internationally, interest rate decisions can affect more than borrowing costs. They can also influence foreign exchange (FX) rates, which may affect supplier costs, overseas revenue and margins. When central banks raise or lower rates, exchange rates often move in response, with knock-on effects for cash flow and planning.
Even relatively small movements in exchange rates can change the value of international transactions. For businesses that buy, sell or hold funds in foreign currencies, understanding the relationship between interest rates and exchange rates can be an important part of financial planning.
This article explains how interest rates influence exchange rates, why central bank decisions matter and what these movements can mean for businesses managing currency exposure.
What are interest rates?
Interest rates are the cost of borrowing money. The higher the interest rate, the more you have to pay back on top of the original loan value. They also impact the return you get on savings. The higher the rate, the better your return.
Central banks like the Bank of England (BoE), the European Central Bank (ECB) and the US Federal Reserve (Fed) set benchmark interest rates that influence borrowing costs across the economy, and commercial banks use these benchmarks to help determine the rates they offer customers.
Why higher interest rates can strengthen a currency
Higher interest rates can increase returns on savings and certain investments, which may make a currency more attractive to some investors. By attracting foreign capital that is searching for higher yields, they increase demand for a currency. That, in turn, can strengthen the currency against rivals. However, a stronger currency can create both opportunities and challenges for businesses. When the pound strengthens against the euro, for example, sales made in Europe may be less profitable, whereas imports are cheaper.
Exchange rates are also influenced by wider economic circumstances. Interest rates are an important driver, but they aren’t the only one.
Why lower interest rates can weaken a currency
Just as higher interest rates can strengthen a currency, lower ones can weaken it. When interest rates are lowered the opposite effect occurs. Foreign capital may withdraw from a currency in search of higher returns elsewhere, demand drops and the currency depreciates (falls) in relation to others. If the pound weakens against the euro, sales in Europe may be more profitable, but imports can become more expensive.
Again, it’s worth repeating that pressure on currencies in either direction can arise from several sources, of which interest rate changes are one. Also, unexpected interest rate changes may move exchange rates more than changes that have been flagged well in advance.
Why central bank decisions matter
Interest rate decisions are the main lever central banks use to influence the economy.
Most importantly, interest rates have a direct impact on inflation. Higher interest rates may help reduce inflationary pressures by increasing the cost of borrowing money. Lower rates may have the opposite effect.
Interest rates also influence economic growth. When borrowing costs are low, businesses may be more inclined to invest, expand operations or increase hiring. In some circumstances, this may support economic growth.
When borrowing costs are high, money is more expensive. In these circumstances, businesses may choose to delay investment plans until conditions become more favourable. This can contribute to slower economic activity.
The usual caveat applies. Other factors also influence the decisions businesses take, but borrowing costs are an important one.
The role of inflation and market expectations
Market expectations are an important factor in exchange rate movements.
When inflation is high, markets may expect interest rate rises as central banks attempt to cool the economy. When economies are subdued and inflation low, markets may expect interest rate cuts to boost activity.
Exchange rates can move in anticipation of future decisions, as markets invest in a currency – or sell it off – because of what they think will happen to interest rates in future.
In fact, market sentiment is sometimes a greater driver of exchange rate movements than interest rates themselves. That can sometimes lead to unexpected exchange rate shifts. Businesses that buy, sell or operate abroad are impacted by these shifts, which can affect supplier costs and overseas revenues. They also add an element of uncertainty into business operations, making financial planning and pricing more complicated.
Other factors that influence exchange rates
Lots of other factors impact exchange rates. Economic growth, employment rates and trade balances can all influence currencies. The relationship between exchange rates and these wider economic conditions can be complex, and interest rates are one of several factors that markets monitor closely.
For example, when an economy is booming, consumers and businesses may buy a lot of goods from overseas, with imports overtaking exports (shifting the trade balance). That increases the global supply of the home currency, potentially devaluing it.
In addition, when labour is cheap and inflation low, the goods produced by an economy may become more competitive in relation to the same goods produced elsewhere. Over time, this may support demand for the country’s exports and, in some cases, contribute to currency appreciation.
Market sentiment is also at work here. When investors expect economic growth, they may invest in the country’s stocks, real estate and other assets. That can strengthen the nation’s currency based on economic forecasting.
Finally, political and geopolitical instability can affect exchange rates. In simple terms, periods of uncertainty can influence investor behaviour and capital flows. In these cases, investment flows will be away from instability and towards stability.
These factors can all influence currency movements, which may affect revenue, cash flow and profitability for cross-border businesses.
How interest rates affect businesses dealing in foreign currencies
Interest rate movements can directly affect profitability, pricing decisions and cash flow for businesses exposed to foreign currencies. Even when sales volumes and supplier agreements stay the same, exchange rate shifts can change the real value of costs and revenue.
Supplier costs
Interest rates impact exchange rates. When the pound increases in value relative to the currency of your supplier, import costs fall. The opposite is also true.
Overseas sales revenue
When the pound appreciates relative to the currency of the country where the sale was made, revenue from the sale decreases when translated into pounds.
Profit margins
Profit margins rise and fall as overseas costs and revenue fluctuate.
Budget rates
If actual rates move significantly away from this, expected profits and costs can differ from forecasts.
Cash flow planning
Exchange rate movements can create differences between expected and actual costs or revenue, making forecasting and cash flow planning more challenging.
Pricing
Exchange rate fluctuations also create uncertainty around pricing. The price you set today may become less profitable if exchange rate movements reduce the value of overseas revenue.
Example: importing goods from the United States
A UK importer pays a US supplier in dollars. When the Fed raises interest rates, investors may buy the US currency, and the dollar strengthens against the pound. The UK importer then might have to use more pounds to pay the invoice, increasing supplier costs and reducing margins if extra costs are not passed to customers in higher prices.
Example: exporting to the Eurozone
A UK exporter invoices customers in euros. When the ECB cuts interest rates, the pound strengthens against the euro. The exporter may receive fewer pounds when converting sales revenue to sterling. Depending on the scale of the currency movement, this could affect revenue forecasts, budgeting assumptions and profitability.
These examples are provided for illustrative purposes only and not an indication of future performances.
What this means for budgeting and cash flow planning
When interest rate changes contribute to exchange rate movements, businesses may experience greater uncertainty around revenues, costs and planning assumptions.
In some cases, budget assumptions may no longer reflect actual costs and revenues if exchange rates move significantly. This can create additional uncertainty around cash flow, import costs and margins on overseas sales. It also puts pressure on pricing management, as businesses try to anticipate FX changes without reducing competitiveness.
Taken together, this amounts to currency risk. If you have FX exposure (i.e. your business deals in more than one currency), interest rate changes that move money markets can impact your cash flow, budgeting and investment plans.
Interest rates and exchange rates: key takeaways
In summary, higher interest rates can strengthen currencies, while lower rates can weaken them.
Inflation plays a major role, but so too do market expectations of how central banks will act to curb inflation or encourage economic activity.
As well as interest rates, exchange rates react to a range of economic and political factors, which sometimes make them difficult to predict.
For businesses, the most important point is that currency movements can affect supplier costs, overseas revenue and margins. In turn, these impact budgeting, planning and pricing.
How businesses manage the impact of exchange rate volatility
Given the relationship between interest rates, exchange rates and commercial outcomes, businesses often consider how exchange rate volatility could affect their operations and overall FX risk management planning.
As part of this process, they may monitor central bank announcements and commentary on monetary policy to better understand factors that can influence exchange rates.
Businesses may also review the exchange rates used within budgets and assess their currency exposure to understand the potential impact of exchange rate fluctuations on costs, cash flow and revenue. Exchange rate volatility can be an important consideration in budgeting, forecasting and wider business planning.
Foreign exchange markets can be volatile and movements in exchange rates may result in increased costs or reduced revenue.
Disclaimer:
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This publication is provided for general information purposes only and does not constitute legal, tax or other professional advice from Lumon or its subsidiaries. It should not be relied upon as a substitute for obtaining advice from appropriate professional advisers. While care has been taken to ensure accuracy, no representation or warranty is given as to the completeness or timeliness of the information.
