rates play a pivotal role in the fluctuations of currency pairs.
The policy rate sets the tone for the bond rates. And the relative attractiveness
of bonds is what drives investors to buy or sell given currencies. Generally,
the higher the relative bond yields in a currency, then the stronger the
currency will be.
That has been a very simplistic description of conventional wisdom. But
in the post-pandemic world, that could be changing.
That said, trading strategies may need to be modified to suit the new
reality. It could explain why some trading strategies aren’t as effective. So,
let’s go over why this is happening, and whether we are looking at a new
normal.
It’s not just the interest rate
Most economies in the world spent a lot of money dealing with the
effects of the pandemic, expanding the monetary base. But they didn’t all do it
in the same way, or in the same amount.
So, while inflation around the globe is generally rising in part due to
fiscal policy, it’s not the same in every country. And the means to deal with
that aren’t necessarily the same, either.
The classic way that central banks reduce liquidity is by raising interest
rates, making borrowing money more expensive.
Money in the modern world is essentially created through debt issuance.
Therefore, if debt is more expensive, then less people will take out loans, and
there will be less circulation. That’s the theory.
But central banks aren’t always right. Case in point, the current
inflation situation, where we are well into month 10 of „transitory“
high inflation.
So, why the disconnect
During the pandemic, interest rates were low, so a lot of companies
took advantage to issue debt.
Sure, there were many firms who went into the pandemic with high leverage
and had to reduce their debt holdings (or simply went bankrupt). Nevertheless,
the total amount of corporate debt increased substantially over the last couple
of years.
Now, the companies that needed money have all stocked up on debt. And
with interest rates rising, they are less inclined to borrow more. Meanwhile,
central banks have been snapping up corporate debt, particularly in Europe, but
not so much in the US.
In the US, the Federal government issued a lot of short-term debt as it
faced down a debt ceiling towards the end of the pandemic. It now must roll
over that debt as interest rates are rising.
It’s supply and demand
On a basic level, prices are determined by supply and demand. With less
corporate issuance, then corporations could demand better terms (that is, lower
interest rates).
However, central banks are pushing to raise rates, meaning that better
terms are not available. So, interest rates are rising, but not
„organically“.
In other words, bond yields aren’t reflecting the market so much as
they are reflecting a push by regulators. And that distortion can have some
unexpected effects down the line, which is where forex comes in.
Central banks regulate interest rates by buying up bonds or selling
bonds. Therefore, if central banks want higher rates, they have to withdraw
capital from the bond market. That is, stack the table in favor of bond buyers.
Those are the people with cash, who hunt around for the best bond yields where
they can park their money.
Figuring out the market forces
gap
It’s natural for capital to flow toward higher interest rates, which
means buying that currency and pushing it higher. That’s normally how forex and
bond yields are connected. But that assumes that interest rates will stay
higher.
Right now, the consensus is that central banks are raising rates to
deal with inflation. Once that’s achieved, then rates would likely moderate. That
said, near-term rates could go higher than longer-term rates (the infamous
„curve inversion“).
When the disconnect happens
Investors generally move their funds based on where interest rates are
expected to be, not necessarily where they are. So even if rates are rising at
the moment, the potential for a retracement in yields in the near term as
central banks moderate their tightening and turn to a more neutral stance,
could be the driving force between currencies.
Thus, it isn’t surprising to see some headlines about how a particular
currency didn’t get stronger despite rising yields. The issue might be that
investors don’t think those higher yields are sustainable. Particularly as more
analysts start hinting that a new recession is coming, and central banks will be
forced to cut rates.