Do Interest Rate Differentials affect Currency Price?

by Trader Rich

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)