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December 2016

Interest Rates Drive Currencies (Or Not)

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Theoretically, interest rates are a key driver of exchange rates. Accordingly, when the interest rate differential between the US dollar (USD) and another currency widens in favor of the USD; one should expect the USD exchange rate to increase versus that other currency.

This logic falls under the “fundamentals” umbrella. My view on fundamentals has not changed over the years. Back in 1986 when I was the senior GBPUSD trader at Manufacturers Hanover Trust, a major player in the Forex market at the time, I was quoted in the Wall Street journal about how fundamentals impact currencies; my response was “there are 14 floors between fundamentals and the exchange rate now”.

Over the years my hardline view of fundamentals has softened. A game changer for me was the 1987 Plaza Accord; the key governments announced they would bring down the value of the USD and they did – 50% in two years!

HOW I USE FUNDAMENTALS

Today I find fundamentals useful as a volatility alert and nothing more. Once the news is released perhaps the knee-jerk reaction is predictable if one does their homework but beyond the initial one or two minute somewhat predictable directional spike – anything goes.

I believe very short trading algorithms take over from there. My strategy is to track the movements on a 5 minute chart and look for “algorithm footprints” to guide me in my trade decisions.

Over the last 37 years I have made a living exploiting small niches in the forex market and presently the 5 minute chart and “finding footprints” is my key strategy. Presently, I only have a single tactic (footprint “tell”) but it is enough.

This footprint “tell” occurs and works well; with or without news.

THE INTEREST RATE / EXCHANGE RATE RELATIONSHIP

Getting back to the relationship between changes in interest rates and changes in exchange rates, I believe there is a positive causation (meaning rising interest rates result in a rising currency and falling interest rates result in a falling currency) but it is not linear. Meaning, it works in broad brush terms but not on a micro level.

For example, here is a summary of the interest rate changes and exchange rate changes since the FOMC (Wed Dec 14th through Friday Dec 16th):

 

 

 

 

 

 

 

 

Since the FOMC, the NZD interest rate has increased 12 basis points; exactly the same number of basis points as the USD increased. So the interest rate differential between the NZD and USD has not changed. One would expect the NZDUSD pair to be unchanged since the FOMC, if interest rates were the solw determinant. However, the NZDUSD pair decreased 247 pips, making it the WORST performing major pair since the FOMC.

The EUR interest rate has decreased 5 basis points; versus the USD 12 basis point increase; the differential has increased 17 basis points in the USD’s favor and that turns out to be the largest basis point increase in the USD’s favor of all the key currencies. One would expect the EURUSD pair to be the worst performer of the majors if interest rates were the sole determinant. However, it turns out the EURUSD pair decreased the LEAST of all the major pairs; making it the second best performer of all the major pairs.

WHAT ABOUT OVER THE “LONG TERM”

 

 

 

 

 

 

 

 

A summary view of 2016 indicates the interest rate / exchange rate positive causation works half the time: It didn’t work for the AUDUSD, NZDUSD, and USDJPY pairs and did work for the GBPUSD, EURUSD, and USDCAD pairs.

WHAT ABOUT OVER THE “MEDIUM TERM”

 

 

 

 

 

 

 

 

The medium term also indicates inconsistencies. For example, the interest rate change for the UK, EUR, and JPY is roughly the same. Yet the GBPUSD went the “wrong way” and the USDJPY went HUGE the “right way”.

BOTTOM LINE

Interest rates are important but they are not linear or consistent over the short, medium, or long term. By the way, I did a study spanning 1995-2007 back in 2008 and came to the same conclusion.

This topic came to mind as I was preparing a 2017 currency forecast for a client.