by Murray Gunn
Updated: June 06, 2017
The following article has been excerpted from Murray Gunn's June 6, 2017 "Currency Insight" page, a section of Currency Pro Services. Watch for more of Murray Gunn's commentary in Global Market Perspective, Interest Rates and Currency Pro Services, and on deflation.com.
The relationship between interest rates and currencies is considered to be strong. If one country has a higher interest rate than another, then in theory, its currency should appreciate as funds flow towards that higher interest rate, and vice versa. This belief is in the DNA of orthodox economic analysis.
Financial news networks spend untold hours debating with their guests as to whether interest rates will rise or fall and the effect that will have on the currency. When a currency is weakening, policy makers believe that raising interest rates will help the currency, and when policy makers think that their currency is too strong, they want to lower interest rates in the expectation that the currency will fall.
This sounds very straightforward in theory. In practice, however, a different story emerges.
Our chart shows the Euro's 3-month interest rate minus the US dollar's 3-month interest rate (black line), charted alongside the EUR-USD exchange rate (blue line) since 2010. The 20-day correlation between the two is plotted in the lower panel. At first glance you may think that a strong relationship exists. Both lines appear to be moving in the same general direction, which is what the orthodox interest rate theory of exchange rates suggests. But look more closely and you will see that there are many periods when this is not the case. The correlation panel shows that the relationship is unstable and, in fact, that there are numerous occasions when the correlation is negative (meaning that the currency and the interest rate differential are moving in opposite directions).
Such as now.
This year the Euro has rallied some 7% versus the US dollar, whereas the 3-month interest rate differential has moved 24 basis points against the Euro and in favor of the US dollar. Traders and strategists who give the myth of interest rate differentials an important weighting have been left scratching their heads as to what is going on. Those following the Elliott Wave Principle, however, understand that it is human herding that drives markets which is why seemingly sacrosanct economic laws are often shown, in reality, to have almost no value.
What the ECB do this week and what the Fed do next week on interest rates may or may not create excitement amongst the financial community. But it would be a mistake to read anything into what it means for the EUR-USD exchange rate.
We will be exposing more market myths on this page in the months ahead.