By understanding and observing these relationships and their patterns, investors have a window into the currency market, and thereby a means to predict and capitalize on the movements of currencies.
What Does Interest Have to Do With Currencies?To see how interest rates have played a role in dictating currency, we can look to the recent past. After the burst of the tech bubble in 2000, traders went from seeking the highest possible returns to focusing on capital preservation. But since the U.S. was offering interest rates below 2% (and going even lower), many hedge funds and those who had access to the international markets went abroad in search of higher yields. Australia, with the same risk factor as the U.S., offered interest rates in excess of 5%. As such, it attracted large streams of investment money into the country and, in turn, assets denominated in the Australian dollar.
These large differences in interest rates led to the emergence of the carry trade, an interest rate arbitrage strategy that takes advantage of the interest rate differentials between two major economies, while aiming to benefit from the general direction or trend of the currency pair. This trade involves buying one currency and funding it with another, and the most commonly used currencies to fund carry trades are the Japanese yen and the Swiss franc because of their countries' exceptionally low interest rates. The popularity of the carry trade is one of the main reasons for the strength seen in pairs such as the Australian dollar and the Japanese yen (AUD/JPY), the Australian dollar and the U.S. dollar (AUD/USD), the New Zealand dollar and the U.S. dollar (NZD/USD), and the U.S. dollar and the Canadian dollar (USD/CAD). (Learn more about the carry trade in The Credit Crisis And The Carry Trade and Currency Carry Trades Deliver.)
However, it is difficult for individual investors to send money back and forth between bank accounts around the world. The retail spread on exchange rates can offset any additional yield they are seeking. On the other hand, investment banks, hedge funds, institutional investors and large commodity trading advisors (CTAs) generally have the ability to access these global markets and the clout to command low spreads. As a result, they shift money back and forth in search of the highest yields with the lowest sovereign risk (or risk of default). When it comes to the bottom line, exchange rates move based upon changes in money flows.
The Insight for Investors
Individual investors can take advantage of these shifts in flows by monitoring yield spreads and the expectations for changes in interest rates that may be embedded in those yield spreads. The following chart is just one example of the strong relationship between interest rate differentials and the price of a currency.
 Figure 1 |
Notice how the blips on the charts are near-perfect mirror images. The chart shows us that the five-year yield spread between the Australian dollar and the U.S. dollar (represented by the blue line) was declining between 1989 and 1998. This coincided with a broad sell-off of the Australian dollar against the U.S. dollar.
When the yield spread began to rise once again in the summer of 2000, the Australian dollar responded with a similar rise a few months later. The 2.5% spread advantage of the Australian dollar over the U.S. dollar over the next three years equated to a 37% rise in the AUD/USD. Those traders who managed to get into this trade not only enjoyed the sizable capital appreciation, but also earned the annualized interest rate differential. Therefore, based on the relationship demonstrated above, if the interest rate differential between Australia and the U.S. continued to narrow (as expected) from the last date shown on the chart, the AUD/USD would eventually fall as well. (Learn more in A Forex Trader's View Of The Aussie/Gold Relationship.)
This connection between interest rate differentials and currency rates is not unique to the AUD/USD; the same sort of pattern can be seen in USD/CAD, NZD/USD and the GBP/USD. Take a look at the next example of the interest rate differential of New Zealand and U.S. five-year bonds versus the NZD/USD.
 Figure 2 |
The chart provides an even better example of bond spreads as a leading indicator. The differential bottomed out in the spring of 1999, while the NZD/USD did not bottom out until the fall of 2000. By the same token, the yield spread began to rise in the summer of 2000, but the NZD/USD began rising in the early fall of 2001. The yield spread topping out in the summer of 2002 may be significant into the future beyond the chart. History shows that the movement in interest rate difference between New Zealand and the U.S. is eventually mirrored by the currency pair. If the yield spread between New Zealand and the U.S. continued to fall, then one could expect the NZD/USD to hit its top as well.
Other Factors of AssessmentThe spreads of both the five- and 10-year bond yields can be used to gauge currencies. The genereal rule is that when the yield spread widens in favor of a certain currency, that currency will appreciate against other currencies. But, remember, currency movements are impacted not only by actual interest rate changes but also by the shift in economic assessment or plans by a central bank to raise or lower interest rates. The chart below exemplifies this point.
 Figure 3 |
According to what we can observe in the chart, shifts in the economic assessment of the Federal Reserve tend to lead to sharp movements in the U.S. dollar. The chart indicates that in 1998, when the Fed shifted from an outlook of economic tightening (meaning the Fed intended to raise rates) to a neutral outlook, the dollar fell even before the Fed moved on rates (note on Jul 5, 1998, the blue line plummets before the red one). The same kind of movement of the dollar is seen when the Fed moved from a neutral to a tightening bias in late 1999, and again when it moved to an easier monetary policy in 2001. In fact, once the Fed just began considering lowering rates, the dollar reacted with a sharp sell-off. If this relationship continued to hold into the future, investors might expect a bit more room for the dollar to rally.
When Using Interest Rates to Predict Currencies Will Not WorkDespite the tremendous amount of scenarios in which this strategy for forecasting currency movements does work, it is certainly not the Holy Grail to making money in the currency markets. There are a number of scenarios in which this strategy may fail:
- ImpatienceAs indicated in the examples above, these relationships foster a long-term strategy. The bottoming out of currencies may not occur until a year after interest rate differentials may have bottomed out. If a trader cannot commit to a time horizon of a minimum of six to 12 months, the success of this strategy may decrease significantly. The reason? Currency valuations reflect economic fundamentals over time. There are frequently temporary imbalances between a currency pair that can fog up the true underlying fundamentals between those countries.
- Too Much LeverageTraders using too much leverage may also not be suited to the broadness of this strategy. Since interest rate differentials tend to be fairly small, traders accustomed to using leverage may want to use it to increase. For example, if a trader used 10 times leverage on a yield differential of 2%, it would turn 2% into 20%, and many companies offer up to 100 times leverage, tempting traders to take a higher risk and attempt to turn 2% into 200%. However, leverage comes with risk, and the application of too much leverage can prematurely kick an investor out of a long-term trade because he or she will not be able to weather short-term fluctuations in the market.
- Equities Become More AttractiveThe key to the success of yield-seeking trades in the years since the tech bubble burst was the lack of attractive equity market returns. There was a period in early 2004 when the Japanese yen was soaring despite a zero-interest policy. The reason was that the equity market was rallying, and the promise of higher returns attracted many underweighted funds. Most large players cut off exposure to Japan over the previous 10 years because the country faced a long period of stagnation and offered zero interest rates. Yet, when the economy showed signs of rebounding and the equity market began to rally once again, money poured back into Japan regardless of the country's continued zero-interest policy. This demonstrates how the role of equities in the capital flow picture could reduce the success of bond yields forecasting currency movements.
- Risk EnvironmentRisk aversion is an important driver of forex markets. Currency trades based on yields tend to be most successful in a risk-seeking environment and least successful in a risk-averse environment. That is, in risk-seeking environments, investors tend to reshuffle their portfolios and sell low-risk/high-value assets and buy higher-risk/low-value assets. Riskier currencies - those with large current account deficits (which you can learn more about here) - are forced to offer a higher interest rate to compensate investors for the risk of a depreciation that is sharper than the one predicted by uncovered interest rate parity. The higher yield is an investor's payment for taking this risk.
However, in times when investors are more risk averse, the riskier currencies - on which carry trades rely for their returns - tend to depreciate. Typically, riskier currencies have current account deficits and, as the appetite for risk wanes, investors retreat to the safety of their home markets, making these deficits harder to fund. It makes sense to unwind carry trades in times of rising risk aversion, since adverse currency moves tend to at least partly offset the interest rate advantage.
Many investment banks have developed measures of early warning signals for rising risk aversion. This includes monitoring emerging-market bond spreads, swap spreads, high-yield spreads, forex volatilities and equity-market volatilities. Tighter bond, swap and high-yield spreads are risk-seeking indicators while lower forex and equity-market volatilities indicate risk aversion.
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