FX and Interest Rates
Back in the 90s globalization was opening eyes to the connection between currencies and rates.
It seems so obvious today but about 20 years ago amid globalization, some people were just realizing the link between interest rates and foreign exchange. Nowadays it’s a given. In fact it’s one of the worries for the US Federal Reserve as it contemplates raising interest rates in the next several months.
FX and Interest Rates
Back in the 90s globalization was opening eyes to the connection between currencies and rates.
It seems so obvious today but about 20 years ago amid globalization, some people were just realizing the link between interest rates and foreign exchange. Nowadays it’s a given. In fact it’s one of the worries for the US Federal Reserve as it contemplates raising interest rates in the next several months.
FX and Interest Rates
Back in the 90s globalization was opening eyes to the connection between currencies and rates.
It seems so obvious today but about 20 years ago amid globalization, some people were just realizing the link between interest rates and foreign exchange. Nowadays it’s a given. In fact it’s one of the worries for the US Federal Reserve as it contemplates raising interest rates in the next several months.
FX and Interest Rates
Back in the 90s globalization was opening eyes to the connection between currencies and rates.
It seems so obvious today but about 20 years ago amid globalization, some people were just realizing the link between interest rates and foreign exchange. Nowadays it’s a given. In fact it’s one of the worries for the US Federal Reserve as it contemplates raising interest rates in the next several months.
cash management solutions that will concentrate cash so that it can be invested or repatriated. Effective cash management and dealing with local bank credit/counterpart risk will remain high treasury management priorities. Collections and disbursements. As with the other Latin countries, payments are primarily by check, and like Argentina, with long float times. Most banks have limited branch networks. Rejected items can take two weeks to collect on. Some banks have attempted to respond to this with special collection services, specifically designed to handle rejected items. Technological Infrastructure. Here, too, the bulk of the technology lies with electronic banking systems. Most banks are able to provided semi realtime reporting on balances and initiate electronic funds transfers.
Interest Rate Consensus Forecast
(Sample countries) Major rates France
10/7/96
3 mo
12 mo
3.3 3.6
3.4 3.7
3.1
3.1 3.2
3.6 3.7
0.4
0.7 0.6
1.1 1.0
1.5
1.8 1.6
2.2 2.2
5.9
5.9 5.9
6.8 6.7
5.0
5.3 5.1
5.4 na
6.9
6.6
7.2
3.6
3.9
4.4
5.6
5.8
6.1
3mo Interbank (PIBOR)
Consensus Futures
3.5
Germany 3mo EuroDM Dep.
Consensus Futures
The above summaries, and those in
part I, should be used as a starting point for efforts to understand the changing (and mostly positive) treasury management dynamics taking place in each of the major Latin American counties.
3mo Yen CDs
Consensus Futures Switzerland 3mo EuroSFR Dep.
Consensus Futures United Kingdom 3mo Interbank
Consensus Futures 3mo Treasury Bills
Consensus Futures Others Australia 90-Day Bank Bills
Consensus Canada 3mo Treasury Bills
Consensus Since the environment is changing rapidly it is therefore important not to rely on information obtained anywhere but from sources on the ground, in country.
3mo Interbank
Consensus Italy
3mo Treasury Bills (gross)
8.1
7.3
6.5
2.8
3.0
3.6
3.2
3.3
3.3
6.8
6.7
6.7
4.8
4.9
5.2
Netherlands 3mo EuroGuilder Dep.
Consensus Singapore 3mo Interbank
Consensus Spain 3mo EuroPeseta Dep.
Consensus Sweden 3mo EuroKrona Dep.
Consensus
Ms. OBrien is a first vice president with
ABN AMRO in Chicago, +312-904-2415. 4
While currency rates are influenced by a
variety of other factors, the globalization of capital markets and increasing capital mobility make interest rates increasingly important.
In looking to manage a firms currency
risk, it is often a good idea to incorporate your view on interest rates. Indeed, the practice of managing the net impact of fluctuations in both FX and interest rates on a given position or portfolio, not the impact of each in isolation, is often promoted to improve risk management. The idea is that there is likely to be some offsetmeaning the net exposure to both rates in that currency will be lessor leverage impactmeaning the exposure will be greater than anticipatedwhich should be considered. To help make this determination, London-based Consensus Economics, publishers of the Foreign Exchange Consensus Forecasts, like other producers of forecast information, will often include interest rate predictions along with their FX view.
Hong Kong
Consensus
Its definitely worth a trip to assess the
situation first hand. It is also useful to coordinate with an experienced local treasury practitioners, either your companys own or another, to focus your fact-finding mission. This along with making the most of your local and international bank relationships can help you keep your practices up to date and ready for regional efficiencies.
Interest Rates &
FX Management
Japan
United States
Keeping up to date
Professional development
Source: Consensus Forecasts survey of 250 economists on 10/7/96
What interest rates tell about FX
In its survey of interest rate trends, included with its October 7 report, Consensus Economics explores some examples of how interest rates affect rates of foreign exchange. The driving influence on currencies are interest rate differentials (the spread between interest rates for the currency pair being analyzed). Given the globalization of capital markets and the mobility of investors to seek higher returns abroad, wide spreads generally will attract capital inflows into the country with higher interest rates, causing the currency to appreciate. However, these higher rates will not always equate with higher returns for the investors flocking to the higher rates. Parity conditions, according to the textInternational Treasurer/October 28, 1996
Currency Management book explanation, will ensure that exchange rates adjust to equalize real returns across currencies. For example, high rates of interest relative to the dollar would tend to be offset by a devaluation of the high interest currency relative to the dollar (or vice versa)though the immediate impact may be to support the currency. Thus, under parity conditions, the currency with a lower interest rate should be at an equivalent forward premium in terms of a currency with a higher interest rate. Over time, arbitrage will drive the markets to equilibrium. This is part of the same conceptual basis suggesting that forward rates are the best predictor of future spot rates. The trick is to determine the change in the real rate differential, and not that in nominal rates. It is typically the former that drives the corrective currency rate adjustments. As Consensus Economics notes, in many cases, higher interest rates are a necessary offset to expected inflation or other economic risks. In these cases, it is important to adjust nominal rates for these factors to determine their bearing on FX. Note that the consensus view for short-term rates often deviates slightly from futures (see table on p. 4) Further clouding the issue, is the fact that while rising rates can support a currency, falling rates may do so also. For instance, if the rate reduction improves the countrys deficit financing burden, where interest rates have been historically high, a reduction can be equally good news for the currency. This is all a way of saying that the relationship between interest rate and currency moves is not entirely straightforward. FX markets may place greater weight on other influences, such as trade balances, which can overshadow the interest rate impact. Consensus Economics shows how this has been the case with Japan (see chart 2). Another factor is that markets tend to discount expected changes in advance, so exchange rates can respond as much to changing expectations as they can to the rate movements themselves. International Treasurer/October 28, 1996
Chart 1 shows the differential
between Eurodollar and EuroDM interest rates future, with the scale inverted, so that a decline in the series reflects a widening in the expected interest rates differential in favor of the dollar. The differential reflects the futures markets changing expectations of the USD/DM rate differential on a particular contract date (in this case, the December 1996 contract). In Consensus Economics analysis, this chart suggests that changes in DM/USD exchange rate have been closely linked to changes in interest rate expectations. However, this relationship appears to have broken down somewhat during July and August. This may be due to changing sentiments on the likely start date of European Monetary Union (see IT, 9/2/96). Changing expectations also play on Canadian/US dollar rates. Chart 3 plots the consensus forecasts for the Canadian and US interest differential 12-months out. It implies that changes in interest rae expectations have historically tended to lead fluctuations in the exchange rate between the two. More recent experience shows a deviation, however, with cuts in Canadian short term rates and expectations for a US rate hike pushing the expected interest rate differential into a negative situation without hurting the Canadian dollar.
Chart 1
Source: Consensus Economics Inc.
Chart 2
Source: Consensus Economics Inc.
No easy answer These examples show the difficulties Chart 3 inherent in using changing interest rate differentials to guide FX management; and by the same token, indicate the complexities of attempts Source: Consensus Economics Inc. to integrate FX and interest rate exposure into a single net position or Monte Carlo simulation, and what-if value-at-risk number. Parity rules and analysis should be used as insurance for historical correlations are useful, but your risk management efforts, as well as cannot be relied upon to hold in every to round out your FX forecast. instanceeven in the Euromarkets, which serve as the paragon example of For information on Consensus Economics, interest parity at work. Stress testing, contact Michael Sykes at +44-171-491-3211. 5
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