Forex, relationship between Interest Rates and Currency

The relationship between a country’s interest rates and currency is a relationship that is academically indissoluble and which logically, at the macroeconomic level, cannot be easily refuted. Yet, looking at the recent (and not just recent) trend in currency markets, we could safely say that this link is absolutely fallacious when it comes to actually seeing the value of a currency, especially when related to all the others on the market. So the link between interest rates and the currency market is invalid or do we have to make some clarifications? In this article we see how to consider all the factors that make up this relationship.

Relevant historical cases: post sub-prime dollar

We don’t have to go very far back in time to see that this relationship can seem absolutely invalid. We are in 2008, precisely between 2008 and 2009 when chaos broke out on the markets due to the subprime mortgage crisis and the failure of one of the most important historical financial institutions globally, Lehman Brothers. To better understand the climate of that period, in addition to Lehman Brothers, another 4 banks had to go bankrupt that night, some of which were forced to mergers that had not been taken into consideration before that moment, the first that comes to mind is the one between Bank fo America and Merrill Lynch, now bundled into a single branded institution BofA Securities.

Liquidity was in short supply, the margins of many forward derivatives (and others) had been burned and gone into the red, liquidity was in short supply. In practice, if we were to compare the American economic system to a human body, we could say that 2008 was like a strong internal hemorrhage that caused such a high blood loss that immediate care and unlimited transfusions were needed as much as possible (might the medical experts forgive me), the patient had to stay alive at all costs. Liquidity was lacking, and here the US government, together with the Fed, promote the Tarp, a securities purchase plan that was used to help the banking and insurance system, a monster of liquidity worth 7700 billion dollars, a figure never seen on the financial markets.

Furthermore, obviously, in this climate of absolute emergency, the Fed lowers the interest rates and brings them close to 0%, all to feed back the economic circuit that had essentially gone into systemic crash. In this context, what will the dollar have done in the following months? Logically, according to academic statements, the dollar had to fall in value in terms of a low interest rate and greater liquidity on the market, there is a depreciation of the currency. Well, from 2009 to 2011 the dollar remained more or less at the lows reached before 2009 and then started going up again appreciating about 40% in 5 years.

Relevant historical cases: The current situation

Since the Lehman crisis we have seen strong market anomalies. The first of all concerns the dollar which, instead of further depreciating, has seen very strong long-term appreciation to the detriment of all other currencies on the market, primarily the euro and sterling. After 2009, the Fed printed money and the financial earthquake also arrived in Europe with the Greek crisis and the Greek near-bankruptcy that would have led, again due to systemic risk, to the end of Europe. Here too, many injections of liquidity into the system, rates brought to 0% and eventually the Euro from 2012 to 2014 goes from 1.20 to 1.40 against the dollar, an appreciation of 15% in 2 years.

An absurd movement considering the global situation. In the following years, after having stemmed the Greek debt problem, the euro collapsed under the blows of inflation that was struggling to take off, indeed, there was a risk of deflation for a long time, so a inflation close to 0% with strong risks on the investment side. In this context we find a currency that has followed the dictates that a low interest rate corresponds to a depreciation of the currency.

The problem comes later, that is, in recent months, when inflation has risen very rapidly, already from before the outbreak of the pandemic and the war in Ukraine, a movement that at a macroeconomic level leads operators to forecast a future and certain increase in the interest rate, a movement that should lead the euro to revalue. Instead, the exact opposite happens, that is, the euro already leaves a depression zone around the 1.10 area to fall, as we have recently seen, below parity with the dollar. The confusion in this sense is absolutely legitimate, so much so that it is necessary to re-evaluate the validity of this statement and contextualize again what has been said so far about the statement “if the interest rate rises, the currency is strengthened. If rates fall, the currency weakens ”.

Interest rates and currencies, a solid bond?

We must first of all specify an absolutely fundamental thing. The currency market is a market, therefore the value of a currency is not determined by the interest rate but by the supply and demand for that currency. Supply and demand are not easily influenced from the outside as the reasons for buying/selling currencies are many and above all relevant based on the current macroeconomic context.

The interest rate is an instrument that has a strong influence on the amount of liquidity within an economic system and not directly on the value of a currency. It is assumed, very roughly, that an interest rate represents the price of a currency, in reality it represents its "cost of money" at that moment, a price that may or may not be cheaper for a currency than to another.

Taking for example the current situation, where the euro has been sold very strongly and the dollar has been bought: the market has probably preferred to buy dollars as the Fed has already pre-emptively decided on a rate hike program that we can define “certain”, at least more than probable and consequently the market has bought dollars, seen as an asset that offers a certain return, unlike the euro. In this perspective, most likely, the moment will come when the ECB will make a valid and "certain" rate hike program, a moment that seems to be very close in temporal order, so it is possible to see a bullish dynamic of the euro at the moment. which the market will think it is convenient to buy euros on the market.

To move the market, considering this link roughly, are the future dynamics of interest rates and liquidity and not just the movement of the latter up or down. As usual, there are no certain rules on the markets, or rather, they exist but they need specifications that better make us understand how market dynamics work, which are by their nature uncertain.

Original article published on Money.it Italy 2022-10-06 08:57:00. Original title: Forex, relazione tra tassi di interesse e valute