More On Exchange Rates and Policy Rate Differentials

Morgan Stanley’s Stephen Len is obviously on the same page as I am about how the rising interest rate differential between Europe and the US is likely to drive short term currency movements:

Policy rate differentials are especially important now for the currency markets, and it pays to focus on central banks these days.

Reason 1. Global monetary paths are diverging, not converging. Among the major economies, only the US has an output gap small enough to support tightening. I doubt either the ECB or BOE will be in a position to tighten rates this year. Many now understand quantitative easing must be terminated by early next year, but no one has proposed actually raising interest rates from zero. Therefore, monetary paths are diverging, with the rest of the world having trouble keeping up with the Fed. This makes the Fed much more important for the USD than in ‘normal’ times.

Reason 2. Global equity portfolios are likely to be out of balance. Since 2003, there have been massive equity flows into Euroland and Japan. Since much of these flows occurred when the USD was still in structural decline, and some of the outflows reflected fears of a USD crash, it makes sense to suspect hedge ratios are quite low on these equity outflows. With the rise in the FFR and resilient dollar, the cost of running these currency exposures is increasingly unjustifiable. The equity market cap-weighted short-term interest rate differential between the US and the major markets is now around 180 bp, and still rising. If the Fed takes the FFR to 5.0% by end-2006, the differential will reach levels last seen in 2000.

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About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".