The tug of war between exchange rates, interest rates and inflation

Interest Rates and Inflation

Interest rates and inflation are a type of tug of war, with interest rates representing the cost of borrowing as well as the return on money market instruments, while inflation rates measure the rate at which prices of goods and services rise over time. 

When inflation is high, central banks tend to raise interest rates to curb excessive spending and cool down the economy. Higher interest rates increase borrowing costs, which should discourage individuals and businesses from taking on debt and investing. This, in turn, helps to reduce demand and moderate inflationary pressures.

Conversely, when inflation is low, central banks may lower interest rates to stimulate economic activity and encourage borrowing and investment. Lower interest rates make borrowing more affordable, leading to increased spending and investment, thus boosting economic growth.

It’s important to note that the relationship between interest rates and inflation rates is not always linear or immediate. There can be lags in the transmission of monetary policy, and other factors, such as fiscal policies, exchange rates, and global economic conditions can also affect inflation dynamics.

Exchange Rates and Interest rates 

The relationship between exchange rates and interest rates is a complex and interwoven aspect of global financial markets. The interaction between these two factors can significantly influence a country’s economy, investment flows, and international trade dynamics. 

Higher interest rates typically attract foreign investors seeking a better return than is available in their own country. This increased investment demand for a currency can strengthen its value, leading to an appreciation in the exchange rate. Conversely, lower interest rates may discourage foreign investors, resulting in a depreciation of the currency’s value through foreign investors disinvesting.

While the relationship between exchange rates and interest rates seems straightforward, numerous factors can complicate it — market expectations, economic conditions, geopolitical events and monetary policies all play a role.

A recent example is the Turkish lira, Turkey has been decreasing its interest rates since March 2021, which has been labelled as highly unorthodox fiscal policy. As a result of this the Turkish Lira has weakened 50% over the past 12 months. The Turkish Central Bank, realising they needed to intervene, decided to raise interest rates 6.5% at the end of June 2023 (the first time they raised interest rates since March 2021). 

In comparison, SA raised interest rates 4.75% since March 2021 and the rand has weakened by about 15% over the past 12 months. 

Does the rand matter when investing abroad? 

As SA investors, we acknowledge that there are compelling reasons to invest assets abroad, whether it be for diversification, increased exposure to other asset classes, mitigation of political risk as well as a hedge against the weakening rand. 

But does the timing of the rand matter when sending funds abroad and does this have an effect on our long term investment strategy? In the short term, yes the rand (in particular rand strength) would have a potentially negative  effect on the investment returns, however most investors would regard themselves as long term investors with a time frame in excess of 10 years and therefore the movement of the rand (which has historically weakened) would favour the long term investor.

A decade ago the rand was R9.89 to the US dollar. On July 5 2023 it was R18.72,  a 6.45% a year weakening of the exchange rate. 

Recent research published by one of the large asset managers in SA found that short term timing of the currency is less important than what investors choose to invest in. Ensuring that you are invested in the appropriate underlying asset class or mix of funds is more important than timing of the exchange rate. 

Offshore investing is a complex and specialised area of wealth management, and it is essential to engage with a financial planning professional to ensure that you are making an informed and appropriate decision for your specific needs. 

• Botha is a certified financial planner and wealth manager at Netto Invest.