Alvin

Hi Dave,

This is my first time posting on this blog. My question for the day would be why does cutting interest rates leads to a declining dollar shouldn't the dollar regains its value with regards to other currencies as more investors overseas will take opportunity to borrow the dollar as a carry trade?

On the other hand, I also understand that when interest rates are lowered, borrowing becomes less attractive and therefore deposit rates decline in tandem. Savers would then flock to safety to and sell USD and buy currencies with higher desposit interest rates.

But still the dollar devalues, could this be an effect in which there are more investors selling USD to get better rates abroad rather than foreign investors buying up the dollar to be used as a carry trade?

A reply on this would be greatly appreciated.

Btw Thanks Dave really love the vids on the subprime...

David Waring

Hi Alan,

Thanks for the comment and I like the question of the day title:-)

You seem to be pretty close in regards to what happens to the currency when a country lowers interest rates however there just seems to be a little bit of confusion on the logistics.

You see when a country lowers interest rates two things happen:

1. All else being equal, it becomes less attractive for speculators to hold the currency of that country because instead of earning the higher rate of interest on that currency they are now earning a lower rate. As there is less incentive to hold the currency then less people are going to buy it and more people are going to sell it putting downward pressure on the value of the currency all else being equal.

2. It becomes less attractive for speculators to hold the debt of that country as in general the interest rates on most types of debt move up and down with the fed funds rate or the interest rate that the federal reserve has been cutting. As there is less incentive to hold the debt of that country less people buy the debt (which creates less of a demand for dollars needed to buy the debt in this case) and more people sell the debt (which also decreases demand for dollars) putting downward pressure on the value of the currency all else being equal.

3. It becomes more attractive for speculators to sell the currency with the lower interest rate and buy a currency with a higher interest rate or other investment where they feel they can earn a higher rate of return.

So I think where the confusion lies here is in the fact that when a currency has lower interest rates than other currencies in the world then, all else being equal it becomes more attractive to sell that currency (therefore driving the value of that currency down) and buy the currencies with the higher interest rates (therefore driving the value of those currencies up.

Hope that helps. If there are any other questions or input on this one please feel free to post below.

Best Regards,
Dave