Interest Rates Move Forex Market

Recent developments in the foreign exchange market prove that it is not just interest rates that drive action in the currency market.  Expectations of future interest rates also matter.   The currencies with the greatest chance of higher short-term interest rates are the currencies receiving the most support from traders.  The few currencies with bad prospects for an interest rate hike are getting hammered, and that will continue as long as expectations stay the same.  Just look at the results in the last 24 hours.  The pound and the Aussie have been the best performers while the Japanese yen continues to sink.

Much of this kind of activity is indicative of a strong carry trade.  Economic policy makers in Japan have been clear in their refusal to raise rates, at least until there are stronger signs of consumer recovery in Japan.  And when the Bank of Japan does start raising the overnight lending rate, they have committed to doing it as gradually as possible.  Japan’s rates are low, and people (investors) are encouraged to seek higher yields.  The can find those higher yields in other currencies, in the US stock market (witness the steady resilience of the market to any drops) and in foreign bonds.

The carry trade is simply an interest rate differential story.  There is a concern as it becomes more popular because that makes it inherently riskier (see Bloomberg’s stories on Japanese and Hungarian housewives engaging in the carry trade and beating the market).  But until the carry trade bet becomes untenable (and that will happen at some point), forex traders continue to reap their gains and push the yen lower.  The euro is at its highest level ever again the yen.  AUD/JPY is at a 15 year high and USD/JPY is at a 4 year high.  And perhaps most interestingly, the New Zealand dollar, the currency with the highest yield, is back to the rarefied levels it occupied before the RBNZ intervention.  The bank would like to push it down again, but it is running out of funds.  And central bank interventions do not usually work anyway.  The bottom line is that as long as the global market stays calm, carry traders will profit on the interest rate differentials.  But world-wide inflation, political uncertainty, a slowdown in the United States or anything else that throws the forex market into flux will put a wet blanket on the carry trade.