Do Interest Rate Differentials affect Currency Price?
I wanted to do a study on my own between the EUR/USD and interest rate differentials so I gathered all historical interest rate data from 1/1/1999 to present. What I found was that there was no correlation between the actual differential and the price of the currency pair. What I did find was the following:
We are in the third cycle of price changes. What I mean by this is that there was an extended period where the USD gained versus the EURO (Cycle #1) and then an extended period where the EURO gained versus the USD (Cycle #2). Currently there has been another extended period where the USD has gained versus the EURO (Cycle #3)
Here are my estimates of cycle length:
Cycle #1 – 01/1999 – 05/2001 BULLISH USD (29 months)
Cycle #2 – 05/2001 – 12/2004 BEARISH USD (43 months)
Cycle #3 – 12/2004 – present BULLISH USD (16 months +)
I found that the most defining point regarding the change of cycle was that it happened right after the interest rate differential between the EURO and USD hit 0%.
Here are the periods of time when the differential hit 0.00%:
5/11/2001
11/10/2004
As you can see, there is a correlation between the differential being 0% and the change of cycle. Unfortunately we have limited data since the EURO has only been in existence for the last 7 years or so.
If I was to use this information to predict the future direction of this currency pair, I would have to predict that the USD will remain BULLISH for quite some time to come. Seeing that the interest rate differential currently is 2.50% and the fact that the Fed may increase rates 2 more times, I cannot foresee this differential decreasing anytime soon.
I don’t know if this study is B.S. or not. There are many other economic factors that can affect currency prices and I didn’t take any of these into consideration such as the US Account Deficit or the Eurozone’s slower GDP growth. In addition, with Iran switching to EURO’s for payment of oil, there are other things in play that make it more difficult to predict the future.
EUR/USD Interest Rate Diff- Excel (20.50 KB 06.03.2006 11:32)
Interest Rate Comments from Morgan Stanley Chief Economist
"As always, central banks are in ultimate control of the liquidity spigot. And policy ‘normalization’ is now the over-arching objective for the Federal Reserve, the European Central Bank, and the Bank of Japan. For different reasons, each of these monetary authorities had to run policies of extraordinary stimulus in recent years — the Fed in response to the post-bubble shakeout of 2000-01, the ECB in response to Europe’s fierce structural headwinds, and the BOJ in response to nearly a decade of corrosive deflation. With those risks perceived as now subsiding, all three central banks are seeking to end their extraordinary accommodation and put their policies on a more neutral setting. The Fed has obviously made the most progress in doing so, whereas the increasingly tough-talking BOJ has yet to act. The ECB is somewhere in-between. But there can be no mistaking the endgame that is now coming into focus: To the extent that a powerful upsurge in the global liquidity cycle has been fueled by extraordinary monetary accommodation, those days are coming to an end."
Stephen Roach
Are Commodity Prices leading indicators for Currencies?
I read a new article (2006-01-25) today by Kathy Lien titled, "Commodity Prices and Currency Movements."
To summarize, there are certain commodities that have a higher correlation with certain currencies.
1. Oil -> CAD (80% correlation)
Price of oil acts as a leading indicator
2. Gold -> AUD and NZD (between 85-90% correlation)
As gold appreciates, so does the AUD and NZD
What I like most is that Gold and Oil could be leading indicators. This graph shows that this could very well be the case in some instances.
You can find the full article at http://www.investopedia.com/articles/forex/06/CommodityCurrencies.asp
Forex Outlook 2006
Saxo Bank has released their 34 page outlook for the global economy and developments in the major global asset classes over the coming 12 months. Features include:
- Outrageous Predictions for 2006
- Asia Goes It Alone
- The US: Rates Top Out
- Europe: What a Mess
- Equities in 2006: Plenty of Risk but Valuations Still Reasonable
- Forex in 2006: JPY strikes back
- Energy in 2006: A Rough Ride Ahead
Educate yourself. Every little bit helps.
Global Economy and Forex Outlook (625.33 KB 10.01.2006 14:06)
January 3rd Committment of Traders Report
The January 3rd Committment of Traders Report was released yesterday. You can view data at http://www.forexproject.com/Forex_Volume/
Sluggish Market Ahead of Payroll Report
The forex market was real slow today attributed to the fact that the first big economic release of the year is tomorrow. Consolidation looks likely to continue until then and maybe the rest of Friday. I would expect the market to react next Monday as it did earlier in the week as we are near many key levels. The dollar is reaching support at the 200 EMA (88.82) as well an uptrend line. It’s currently stalled at the .500 fibonacci level after pushing slightly through it yesterday.
; "Dollar Index Chart")
Expectations for non-farm payrolls tomorrow is 200K and a 5% unemployment rate. I want to remind everyone that the direction of the market after the release of the payroll report tomorrow is the hardest to forecast. Here is a post I made a couple of months ago:
I was reading Currency Trader magazine and it is interesting to note that the payrolls report which is released this Friday is very difficult to forecast. According to the article, no matter what the forecast is, the forex market will spike on it, sometimes in both directions on the same day. This is why it is not recommended to open a position in the morning on the first Friday of each calendar month.
According to an analysis by S.A. Johnston, on the payroll date each month from January 1999 to September 2005, the Euro had 42 payroll date-days closing up and 36 days closing down. The maximum spike up was 240 points and the maximum spike down was 249 points.
2006 GDP Growth Forecast
| Country/zone | 2005 (%) |
Source |
2006 (%) |
Source |
| World Economy | 3.2 | World bank | 3.3/3.2 | JP Morgan Chase/Moody’s |
| U.S. | 3.7 | Credit Suisse | 3.7 | Credit Suisse First Boston |
| Eurozone | 1.5 | Westpac | 2.0/1.9 | JP Morgan Chase/Westpac |
| Japan | 1.0 | Moody’s | 2.5/1.6 | JP Morgan Chase/Moody’s |
| China | 9.3 | Moody’s | 8.7 | Moody’s |
| Latin America | 4.0 | Credit Suisse | 3.7 | Credit Suisse First Boston |
| South Africa | 4.2 | South Africa | 4.0/3.9 | Moody’s/IMF |
Source: Currency Trader Magazine
Interest Rate Outlook 2006
| Country/zone | Rate (%) |
Current cycle |
2006 outlook |
| U.S. | 4.25 | Hike | Rate hike cycle expected to end in first half |
| ECB | 2.25 | Hike | Additional rate hikes seen |
| UK | 4.5 | On hold | Potential for rate cut seen |
| Switzerland | 1.0 | Hike | Additional rate hikes seen |
| Japan | 0 | None | Rumors BOJ will abandon zero interest rate policy |
| Canada | 3.25 | Hike | Additional rate hikes seen |
| Australia | 5.50 | On hold | Balanced risks seen, rates on hold |
| New Zealand | 7.25 | Hike | On hold, potential for rate cut late in 2006 |
| Brazil | 18 | Cut | Continue loosening rates |
| South Africa | 7.0 | Cut | Fund managers/economists differ on outlook |
Source: Currency Trader Magazine
US Consumer Price Index Report
We didn’t see much volatility after the CPI report this morning. The Core CPI figure of .2% was the consensus estimate and the CPI figure was -.5%, .1% above the consensus estimate. I interpret this report as meaning that inflation is generally under control with the -.5% CPI decrease attributed to the lower gas prices in November.
But the gas prices have begun their crawl back up this month so I can see an increase in CPI for December with Core CPI stable during the January announcement. I don’t foresee these figures having any bearing on future Fed rate decisions.
