The interest rate differential has defined as the difference in the interest rates for each of the two currencies in the currency pair. Each currency has its own interest rate and the difference between the interest rates are the rate differential. In foreign exchange (forex) markets, the differentials or forex interest rate differentials are of interest since they affect the pricing of a particular currency. Purchasing a currency which is having a higher interest rate is profitable, since the trader will get daily interest payments. This forex purchase is defined as carry trade or earning carry on the rate differential. Since 2010, changes in the economies worldwide, have resulted in negative interest rates in some countries and people are more interested in the differentials in interest rate.
For example, you plan to buy or sell the USD/JPY for 2-years. You will either receive 2.68% when you try to buy the dollar or pay away 2.68% if you buy the yen and sell the dollar. This exchange differential exist because the 2-year US rate is 2.50% and the Japanese 2-year yield is -0.18%. If you buy the US dollar and nothing happens for 2-years you will earn 2.68%. If you buy the Japanese yen currency pair and sell the dollar and nothing happens for 2-years you will lose 2.68%. This example is based on interest rate differential.
Negative interest rates
Since 2014, economists have noticed a major difference in the interest rates for the economies of developed countries and the economies in emerging markets. The economies in developed countries reduced their interest rates to below zero, in an attempt to increase demand for products and services. On the other hand, the emerging market countries increased their interest rates, hoping to prevent instability in the economy and reduce the outflow of capital. For example, in February 2016, Banxico, the central bank of Mexico, in an emergency meeting decided to increase the rate for borrowing by 50 basis points. It also sold United States dollars at the applicable market rate, to increase the demand for the Mexican peso, whose value was falling. This decision increase the difference in the interest rates of Mexico and the United States. The market interpreted this decision by the central bank, as a sign of desperation or instability to prevent chaos in the global market. This is how forex interest rate differentials can change a lot of things.
Forex traders try to take advantage of the below-zero interest rates in some countries with carry trade. The forex traders are selling currencies having negative interest rates like the euros and Japanese yen and using the money to purchase currencies with a high-interest rate like the Indian rupee, Mexican peso, South African rand, or the Turkish lira. Theoretically, these trades may appear very profitable, due to the very large differentials in the interest rates of the countries. However, in reality, these may become extremely risky if the economic problems in the emerging markets continue or worsen.
Forex traders should be aware that historically it is observed that there is often a change in the spread for the currency pair, and this could neutralize the interest which the forex trader is making due to carry trade for the forex pair. Rate differentials are usually widening because the risk is creating problems for the borrowers in the countries. New forex traders should be cautious while considering carry trade since it is fairly risky. In 2019, there have frequent fluctuations in the commodity rates, and trade disputes between the US and China have adversely affected the yield for some of the currencies having higher interest rates. Also, uncertainty about the future has led to an increase in investment, the flow of funds to countries which have low or negative interest rates