Currency values ​​are in a fierce tango with interest rates

The EU euro has just broken parity with the dollar for the first time in about 20 years. The Japanese yen is down almost 20% since the start of this year and 30% since the start of 2021. The trade-weighted US dollar is up almost 10% since its recent low in June 2021. Movements Important such numbers among the world’s hard currencies are rare and usually signify a “retreat to a safe haven”.

Peeling the onion skin off recent movements in the US dollar would suggest that changes in its exchange value have generally reflected an increase in real interest rates in the United States. While the real yield on the US 5-year bond has fallen from -1.5% at the start of this year to around 0% today, the dollar has appreciated by around 10%. It is as it should be. The principle of interest rate parity (IRP) suggests that one country’s currency will rise against another when its real interest rate rises in such a way that the returns of the hedged currencies remain the same. Note that the US dollar has reversed almost all of the ground it lost against other currencies at the start of the covid pandemic.

Even though euro zone inflation reached 6.8%, the European Central Bank (ECB) was slow to raise rates. The first ECB rate hike of 25 basis points is expected in July. Thus, part of the strength of the dollar against the euro can be attributed to a lack of confidence in the action of the ECB to fight against inflation. In 2022, the surprise factor for the ECB has been the war in Ukraine, which has simultaneously fueled inflation and put pressure on EU economies to find alternatives to Russian oil and gas. This has made the ECB’s job tricky as it seeks to balance inflation and economic disruption. Markets have seen a 180 basis point rise in euro rates over the next 18 months, but that trajectory may need to change if recession hits in early 2023.

Japan’s central bank has been adamant that it will not raise rates or undertake quantitative tightening. Along with interest rate differentials, this means the yen has fallen to its lowest level in 24 years against the dollar. Against the backdrop of current global inflation, Japan has strived to create modest and sustainable inflation over the past three decades. The Bank of Japan is reluctant to compromise this objective in its response to current threats.

The Bank of England (BoE) has already hiked rates five times this year. Reflecting the UK’s particularly fragile relationship between higher rates and slower growth, the BoE warned UK banks to shore up their capital base. He signaled that he will likely ask lenders to hold more risk-weighted assets, a so-called “countercyclical buffer.”

With the world’s four major central banks out of sync in terms of speed and direction, global currency markets are in turmoil. Asian currencies recorded their worst quarter since the 1997 Asian crisis. The Indian rupee is down around 7% for the year, the Pakistani and Sri Lankan rupees fell precipitously, and even a commodity-based currency commodities such as the Brazilian real has depreciated by around 13% over the past two months. It could be called Taper Tantrum 2.0, after a similar period in 2013. Of course, at that time inflation was not as threatening, so the possibility of big rate hikes was limited.

The relentless rise in the dollar has broken the back of the Sri Lankan economy and is expected to accelerate a $1.17 billion bailout deal from the International Monetary Fund (IMF) for Pakistan. This first tranche of a global package of 7 billion dollars will mark the revival of the 22nd IMF agreement for Islamabad. The Turkish Lira has lost 23% this year on top of a 44% loss last year. Turkish inflation is now 79% per year, mainly due to the lack of a credible monetary response exacerbated by the rise in the dollar. Turkey risks joining a club with Venezuela, Sudan and Lebanon. These countries have three-digit inflation rates with currencies depreciating sharply.

The Indian rupee has depreciated by around 3% per year against the dollar over the past 10 years. Given that this incorporates two tantrums, this performance is better than usual for India and better than average for emerging markets.

The main reasons for the better overall performance of the Rupee are the framework adopted by the country in 2016 for a nominal policy anchor through a Monetary Policy Committee (MPC) and the availability of a large cache of reserves. foreign exchange (now about $600 billion) to help stabilize the currency. in times of stress. These foreign exchange reserves have remained strong because India is one of the few major economies in the world with rapid and sustained growth, which attracts inflows.

Although the MPC was only able to contain inflation below the average target level of 4% for a short period, it did reduce inflation volatility.

If the Reserve Bank of India draws some lessons from its own handling of the 2013 taper tantrum, there is no reason to be too pessimistic on the rupee. These lessons include raising interest rates cautiously, increasing friction on gold imports (duties have been raised), measures to attract more foreign capital, establishing a currency exchange for oil companies, thus reducing the demand for dollars and reducing the export. flow of funds from both businesses and households.

If the government focuses on broad and inclusive growth strategies, the Indian rupee can further slow its annual depreciation against the US dollar.

PS: “If you get tangled up, keep tango,” said American actor Al Pacino.

Narayan Ramachandran is President of InKlude Labs. Read Narayan’s Mint columns at

Catch all the trade news, market news, breaking news and latest updates on Live Mint. Download the Mint News app to get daily market updates.

More less

To subscribe to Mint Bulletins

* Enter a valid email

* Thank you for subscribing to our newsletter.

About Louis Miller

Check Also

Global central banks expected to hike rates this week

Yahoo Finance’s Jared Blikre breaks down Wall Street’s expectations for upcoming central bank policy changes. …