• PAGE ONE
• INDEX
• HOME

Interest differentials alone do not drive currencies

T. B. Kapali

IT was a somewhat jumpy move in dollar/yen towards the close of the previous week -- with the pair rising up to 108 levels after range-trading for some time around 104/105. Receding prospects of a Japanese rate hike were the immediate trigger for the upm ove in dollar/yen.

Last week's development apparently (and obviously) indicates that higher interest rates would quite clearly support a currency. Continued softness in Japanese interest rates, therefore, would be bearish for the yen prima facie.

But is that so? A study of movements in this currency pair over the past one-and-a-half years along with movements in dollar and yen interest rates in the same period appears to indicate that forces other than pure interest rate differentials may be driv ing this currency pair.

Indeed, dollar/yen may be on a long-term downward path dictated by the persistence of high trade deficits in the US. That is, it is quite possible dollar/yen is on a path which could, over the long-term, bring down the imbalances in the US external secto r.

This phenomenon may have acquired particular significance in the past year or two during which period some notable changes seem to have come about in the structure of the market. For instance, hedge fund activity in the currency markets -- particularly i n dollar/yen -- is estimated to have thinned down considerably ever since the financial crisis of 1997-1998.

The rather unpleasant experience of 1998 -- when the dollar went down all the way from yen 147 levels wiping out, in the process, the carry-traders -- may well have imposed some fundamental constraints on the hedge fund business itself.

That is, a segment of the market which relentlessly targeted the interest differential between the dollar and the yen -- borrowing in yen at very low interest rates and investing in dollar assets at much higher interest rates (in the process bidding up t he dollar) and leaving currency risk largely uncovered (the old trick of uncovered interest arbitrage on the expectation of continued yen weakness) -- now appears to have been considerably weakened.

This marginalisation of hedge fund activity in currencies -- one cannot still say they are totally out of this market -- may have greatly weakened the momentum of dollar bids in the market and, as a corollary, weakened the momentum of yen offers also. Th at is, it is quite possible that technically-driven short-term overshootings in currencies -- of the type which hedge funds can typically cause -- may well be on a long-term declining trend.

More fundamental factors then come into play to affect currencies.

Dollar interest rates being higher than yen interest rates, of course, is a fundamental factor which should favour the dollar. But one is looking here at more basic issues -- as to what keeps dollar rates at levels higher than yen interest rates. That fo cus on the underlying reason behind higher dollar interest rates means that the dollar need not necessarily and always remain bid against the yen. The accompanying chart on rate differentials and currency movements point to such an environment possibly d eveloping in respect of dollar/yen.

Higher dollar interest rates are necessary to counter possible price pressures as aggregate demand in the US economy runs persistently ahead of aggregate supply. And, as long as demand remains ahead of supply, higher rates may not automatically translate into a stronger dollar. The rather volatile moves in dollar/yen over the past year-and-a-half despite interest differentials between the two currencies widening in favour of the dollar, could well be indicative of such a state of affairs.