The US Dollar may be one of the top winners among the major currencies as markets settle into a long-term environment of low economic growth, low interest rates, and low inflation. The Japanese Yen looks the least attractive, followed closely by the Australian and New Zealand Dollars.
[B]Low Inflation, Low Interest Rates Are Here to Stay[/B]
The world’s top economies are seemingly in for a period of low growth, low inflation, and low interest rates at least through the end of next year. The International Monetary Fund (IMF) forecasts advanced countries will see GDP shrink -3.8% this year and rebound just 0.6% in 2010; on the inflation front, consumer price growth is expected to average 0.5% over this and next year, the lowest in at least four decades. Reasonably enough, bond yields suggest that traders are pricing in the likelihood that central banks across the G10 will keep rates at or near historic lows well into 2010.
[B]How Do We Trade This? Case Study - Japan[/B]
Interest rates are arguably the most dominant driver of exchange rates, and relative stability on this front in the coming quarters has made for choppy price action and unusual cross-market correlations (specifically between FX and equity markets) as traders try to divine the next catalyst for directional momentum. And yet, history does offer a benchmark case study that offers a guide for how to navigate the kind of environment that we are now faced with. Indeed, looking at the post-1971 period after the Gold Standard fell apart and the current system of free-floating exchange rates came into existence, Japan stands out as having experienced consistently low (and often negative) consumer price inflation since 1974. Also rather conveniently, the Bank of Japan had implemented a wide range of benchmark interest rate regimes ranging from as high as 9% to famously as low as 0% while inflation stayed relatively flat, allowing us to mine a for a pattern in a diverse range of observations. This helps to place how counties with different policy rates but facing a similarly low-inflation world will see their currencies fare in the next 12-15 months.
[B]Real Interest Rates Guide Currencies’ Outlook[/B]
To get a solid reading on a currency’s true return, we discounted nominal benchmark borrowing costs (as set by the Bank of Japan) by the annual CPI growth level (a proxy for inflation) to get an estimate of the real interest rate. Comparing this with the value of the Yen, it is immediately apparent that the two are trending in opposite directions:
To quantify the relationship more precisely, we used a linear regression study to find that, indeed, the relationship between real interest rates and the Yen was an inverse one. Further, close to 70% of the variance in real interest rates explained the variance in the Japanese unit’s value:
Why could this be the case? If inflation is unusually low (below 2%, to use the reference level of most central banks) or even negative, consumers and businesses hold off on spending and investment because expectations that prices may fall (or continue to fall) in the future encourage them to wait for the best possible bargain. This also encourages a specific preference for cash: costs are expressed in terms of the relevant currency, and slowing or falling price growth amounts to an increase in that currency’s purchasing power.
[B]What Does This Mean Going Forward? [/B]
To apply what we see in the above analysis, it would make sense to look at where real rates are expected to stand in the months ahead. To do this, we discount the 3-month LIBOR interbank market yield on each of the major currencies by the expected fourth-quarter CPI reading from a survey of economists conducted by Bloomberg:
[I]Source: Bloomberg[/I]If our thinking is indeed correct, the currencies with negative real interest rates should outperform in the months to come at the expense of those where real rates are higher, pointing to gains for the US Dollar and British Pound at the expense of the nominally high-yielding antipodean currencies and the Japanese Yen.
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