(the basis for this page is the inflation and interest rates page)
If a country sees high inflation and/or high wage increases (historically the main driver of inflation) thanks to an improving economy, then the central bank is obliged to raise the key interest rates. If the country has a good rating, then the currency typically appreciates.
The logic is identical to that behind any investment. The investor seeks the highest returns possible provided that the investment seems to be sufficiently secure. Countries that offer the highest return on investment through high interest rates, economic growth and growth in domestic financial markets tend to attract the most foreign capital.
As you can see, it is not just the rate itself that is important. The direction of the interest rate can act as a good proxy for demand for the currency. The direction of the interest rate is obtained through the central bank’s language in the statement that accompanied their target rate decision. The accompanying statement is analyzed word-for-word for any signs of what the central bank may do at the next meeting. The interest rate decision itself tends to be less important than the expectations for future interest rate moves.
High and increasing rates at the beginning of an economic expansion can generate growth and value in a currency. On the other hand, low and lowering rates may represent a country experiencing difficult economic conditions, which is reflected in a reduction of the currency’s value.
The Interest Rate Differential
For years, there were rather big interest rate differentials between G10 economies. For years Japan offered nearly zero percent, while other countries hiked rates to fight a housing boom and economic overheating, the period of the “global carry trade”.
In early 2009, a new carry trade started: The worldwide economy was bottoming out as the United States’ credit freeze began to thaw. The Fed kept U.S. interest rates at all-time lows while the Reserve Bank of Australia began their process of increasing their target benchmark rate thanks to a boom in China.
Since this was at the beginning of an economic expansion, foreign investors into Australian companies needed Australian Dollars to make their investment. Additionally, FX traders began buying the AUDUSD currency pair in anticipation of this demand for the Australian Dollar.
Until 2012, unconventional monetary policy and Quantitative Easing weakened the US dollar. Investors flew into Emerging Markets and “commodity countries” like Australia, New Zealand, Norway and Canada.
The End of the Carry Trade
With the US recovery and the Chinese slowing in 2013, however, everything seems to have changed. Investments in Australia and Emerging Markets (EM) are reduced.
US Investors seem to prefer the American housing market to global investments. Global interest rates gravitate to zero, even in the countries like Australia, New Zealand and Norway, central banks speak about weak inflation, cutting rates and overvalued currencies. EM central banks needed to intervene to sustain their currencies. Increasingly central banks speak about macro-prudential measures - e.g. more equity capital for banks- to fight excesses in the housing market instead of hiking rates.
The Carry Trade Era between 2003 and 2007: undervalued franc
During the carry trade period between 2003 and 2007, the euro strongly increased against the Swiss franc to 1.68. But from 2004 to 2007 the Swiss GDP growth was on average 0.5% stronger than the one in the Eurozone.
The EU-Swiss bilateral agreements helped to increase the number of foreign workers by 23% between 2005 and 2011, whereas the number rose only by 10% between 1992 and 2005. As opposed to former migrations into Switzerland this time foreign employees are mostly highly qualified. Since German wages were relatively low (see previously) German personnel like engineers and computer scientists found it attractive to work in Switzerland and were quickly integrated thanks to the common language. The increasing migration caused rents to go up by more than 2% per year between 2006 and 2009 even during the global financial crisis. Wages increased similarly.
Swiss inflation was low and considerably lower than in the euro zone. The reasons were:
- Lower inflation in all industrialized countries than previously thanks to an aging population and cheap imports from developing nations like China
- Slow growth and slow wage increase in both Germany and Switzerland between 1997 and 2004 (see 3.1.)
- Moderate increases in Swiss housing prices compared to most other countries thanks to more rigid bank requirements after the bad experience of the Swiss housing bust in the 1990s.
- Lower dependency of Swiss companies on the rising oil prices thanks to increased use of water and atomic energy and resulting lower commodity price inflation than the one of the euro zone.
- Further opening of the Swiss market to foreign companies and imported products reduced prices (examples: German low-cost retailers Aldi and Lidl came to Switzerland)
The global carry trade favored high-yielding currencies against low yielders like the yen and the franc. The Swiss CPI was consistently under the SNB price stability target of 2%. Therefore the SNB did see any need to raise interest rates till inflation had become a bit stronger in 2006 and the ECB first started to hike rates. Even if the US housing market started to tumble in 2007, Swiss real estate continued its rise.
The SNB ignored the stronger growth in Switzerland than in the Euro zone : Swiss rates remained steadily between 0.75% and 1.25% under the ECB rates . This gap together with a high risk appetite caused an undervaluation of the Swissie between 2004 and 2010 in terms of the real effective exchange rate and purchasing power parity.
The Reverse Carry Trade
Another Forex rule states that a state with a current account deficit needs to re-compensate this lack of safety via higher interest rates. With low debt, a positive current account and a positive net international investment position (NIIP), the country typically obtains a good credit rating. All these factors help to reassure investors that their money is safe.
If a state experiences the opposite, high debt or a weakening current account balance, this drives money out of the country and weakens the currency. Consequently it causes inflation to rise. The central bank then often hikes interest rates that attracts capital again and slows inflationary effects.
Till the 1990s the Bank of Italy followed this principle and was regularly constrained to hike rates against the Lira’s depreciation with the effect that Italy had to pay higher interest on its bonds. This drove Italian public debt/GDP to far over 100%, but kept the country competitive.
The appreciation of the Swiss franc since the financial crisis is the manifestation of the reverse carry trade.
In summer 2011, the rate differential between the euro zone and Switzerland arrived at 1.5%, but despite this widening interest rate differential, the EUR/CHF depreciated to parity. The reason was the high importance of risk averseness in the form of the reverse or inverse carry trade.
Inflation, Reverse Carry Trade and the Influence on the EUR/CHF Exchange Rate
The SNB cap on the franc does the same as the Bank of Italy did: it protects the Swiss current account surplus. We will see that similarly to what the Bank of Italy did, this cap on the franc can only end in higher public debt, in this case via SNB losses. Therefore, we think that the euro zone will need to offer at least 1.5% to 2% higher interest rates than Switzerland so that the SNB is able to sell (a big part of) their currency reserves.
Peripheral wages must fall in comparison to German or Swiss salaries in order to make the periphery competitive again. For this reason inflation pressures and interest rates in the euro zone will be subdued. Similarly, as previously in Greece or Ireland, Spanish or Italian inflation might fall to levels between 1% and 2%. Spanish companies did not reduce salaries, but due to inflexible labor laws, they fired especially younger personnel.
Even if some inflation pressures in Germany, Finland and Austria exist, we do not think that the ECB will opt for big interest rate hikes in the next 3-5 years. The main chance to sell reserves for the SNB would be a return to the carry trade period, but given the persisting risk differentials this is extremely unlikely.
Must a carry trade always end in a currency crash?
The following paper from the NBER shows that a carry trade may often end in a currency crash.
Here the direct access to Carry Trades and Currency Crashes
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and we encourage you to complete your own due diligence when making an investment decision. Even if we often write about Forex trading, our advices aren't written for day traders who follow technical channels, but rather for mid- and long-term investors. Our aim is to show discrepancies between fundamental data and current asset valuations, which can lead in mid-term to an inversion to technical channels.