New FX Volatility Likely (Stay Tuned)

Some Comments on Recent Exchange Rate Activity 

The FX markets are critical to smooth functioning markets. Sooner or later EVERY piece of international trade will involve a foreign exchange transaction. That is one reason the FX market is by far the largest market in the world. Another factor is the amount of currency speculation that occurs. Here we simply have those buying and selling solely to try to benefit from anticipated price movement. Finally we have hedging activities, those taking offsetting positions to reduce the overall volatility in a firm or trader’s P&L. These are just some of the factors that affect the FX market, which includes currencies and derivatives.

Some recent actions point to the possibility of increasing exchange rate volatility in the near future.

  1. Japan has recently begun a change in their macroeconomic management of the Japanese economy. Their desire to cure the deflation which has been hurting the Japanese economy is likely to cause an increase in the inflation rate. This can cause a weakening of the Yen relative to other currencies
  2.  Thailand is considering capital controls and interest rate actions to cool the rise in the Baht
  3. The US has had very low interest rates for several years as the Fed has been trying to manage the economy back to health. At some point interest rates in the US are likely to rise from their current levels. This will likely cause some increase in exchange rate volatility.
  4. Problems with the Euro have been plaguing the world, although based on member country interest rates, it appears that markets have calmed down a great deal

While many factors affect currency markets, here is a quick overview of three key relationships affecting exchange rates. We are describing each factor independently even though they are interactive and NOT the only factors affecting exchange rates.

  1. Interest rate differentials between two countries can affect exchange rates by making investments in the higher interest rate country relatively attractive. This comes from two potential sources. First, the higher interest rate can potentially offer a more attractive rate of return. Second, if the rate is believed to be ‘high’ and likely to come down, there will be a potential capital gain earned should rates decrease. This can translate into an enhanced rate of return for the investor.
  2. Inflation rate differentials can affect exchange rate by causing a devaluing of one currency relative to another. Generally speaking, the exchange rate between two currencies will depreciate relative to the difference in the inflation rates between the currencies. Inflation tends to weaken a currency and so we could expect the inflation rate differentials to drive a wedge into the exchange rate
  3. The Fischer effect (named after Irving Fisher) states the nominal rate of interest is related to the sum of the real rate of interest and the expected inflation rate (while this is not literally the relationship, it is close enough for what we are discussing here). As inflation rates rise nominal interest rates should tend to rise with them, although there is often a time lag. If inflation rates rise (as some think likely) expect nominal rates to rise.

In general, an increase in the level of rates tends to raise the measured volatility of those rates. In other words, volatility tends to be higher as the LEVEL of rates gets higher. So if rates go up in the near future (for any reason – inflation, commodity prices, etc) we can expect a corresponding increase in exchange rate volatility.

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