If you are considering investing in foreign currencies, you should know about interest rate differentials (IRD). IRD represents the change in interest rates between two currencies from two different countries. It is a measure of how money from two different countries compares. Using IRDs is a crucial matter of interest in the foreign exchange (forex) markets for pricing reasons.
Concept of Negative Interest Rates
Starting in 2014, experts began to see a wide gap between interest rates in advanced markets versus those in emerging markets. Advanced economies drove their rates below zero to try to stimulate demand. At the same time, emerging markets raised their rates to limit capital inflows and to counter economic instability.
Carry Trade
Forex traders focus on exploiting the policy of negative interest rates through carry trading. They do this by selling euros or Japanese yen (or any currency with negative rates) and buying currencies from emerging markets like the Indian rupee or Turkish lira.
Forex Traders Exercise Caution
The old saying “too much of a good thing may not be good” can apply to IRDs. In other words, when the gap widens significantly, it happens because the risk is seen as a threat for borrowers in those countries. A large gap may seem like a good way to make money, but it may also indicate underlying problems.
If you are a new forex trader who has just heard about carry trading and are considering joining, beware. You might see currencies with negative interest rates that seem good to sell or promising emerging market currencies to buy. You need to think deeply about the reasons for each. For example, in recent years, recurring tensions in commodities and concerns regarding trade disputes between China and the United States have put pressure on currencies that offer higher yields.
At the same time, some people who are anxious about negative interest rates, as well as uncertainties regarding other monetary policies like quantitative easing, are directing their money toward safe assets. These assets often have the lowest rates. However, they do not lose value during tough economic times and may also gain value.
Source: https://www.thebalancemoney.com/what-is-an-interest-rate-differential-1344962
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