An interest rate differential is the spread between the prevailing interest rates in two countries. All else being equal, capital flows to countries offering higher interest rates, which benefits those currencies.
In a time with historically low interest rate yields worldwide, traders will often accept greater risk to seek out those markets offering the highest yield. In the U.S., the Federal Funds rate is at 2 percent after the Federal Reserve raised the rate .25 points at its Nov. 9 meeting, while New Zealand has an equivalent rate of 6.25 percent (the next meeting is this month, with no hike expected), making the New Zealand dollar (NZD) a more attractive currency to hold than the U.S. dollar (USD) in terms of yield.
However, the NZD’s yield does not represent a risk-free rate. If the NZD depreciated vs. the USD during the time of your investment in New Zealand, the rate differential advantage could be wiped out. Hence, gaining an extra 4.25 percent (the difference between the two rates) per annum while also enjoying the potential capital appreciation on the long NZD position itself has been a logical move for many traders.
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