What Is Not Seen

A real interest rate is an interest rate that is adjusted for inflation. Since inflation is hard to measure, we get a rough estimate by subtracting consumer price inflation from nominal interest rate.

The real interest rate is usually measured for long term government bonds, like 10y Treasury Bonds, but it can also be estimated for any other interest yielding asset.

Looking at historical U.S real interest rates, we see that they have been negative since November 2007. Compared to Euroland, real interest rates in U.S. have been significantly lower since September last year. During this time the dollar lost a significant amount of value compared to the euro.

Why then are low real interest rates sometimes bad for a country’s exchange rate? First, it is important to realize that the value of one currency is always in relation to the value of other currencies (or assets, like gold).

There are two main reasons for foreigners to be holding dollars, either they are holding dollars to buy American goods and services, or they are holding dollars to earn interest on their savings.

For any investor, both of these objectives are discouraged if real interest rates are low, especially if they are lower than real interest rates in other countries. This is because low real interest rates suggest high inflation and smaller potential real return for foreign investors, which result in decreasing demand for dollars relative to other currencies.

For example, if a foreigner deposits money in a U.S. bank account, where real interest rates are negative, he would be experiencing a net loss, as the rate of inflation are higher than what he earns in interest, urging the investor to stay away from dollars. This is why a negative real interest rate often coexist with a falling exchange rate.

Looking at the long term picture for dollar/euro, real interest rates are an important factor to monitor. Until the divergence between the U.S. dollar and other currencies decrease, I don’t expect to se much change in the long term negative trend for U.S. dollar.

Although, short term corrections will always occur sooner or later as they are drive mostley by investor sentiment, and not by fundamental factors. For short term guidence I rather rely on the supply and demand analysis provided by Point & Figure charting.

Because of a business trip to Luxembourg, I have not been able to comment on some important news during the week. Looking back, we saw that:

(1) Euro/Dollar traded for the first time in history above the 1.60 level. We are now starting to see additional signs of a European economic slowdown. According to the Manufacturing Purchasing Managers Index (PMI) released by the NTC Economics, manufacturing weakened in April. The strong euro affected New Export Orders as they contracted for the first time in almost three years, from 51.1 to 49.8.

Some countries and sectors in the Euro Zone will likely cope better than others, as the euro strengthen against the dollar. Strong Chinese demand will primarily benefit the exporting sector related to capital goods and high tech consumer goods, mentioned here.

(2) Chinese foreign exchange reserves recorded a record increase in the first quarter. China added $153,92bn to their current reserve, compared to $94,63bn in the forth quarter of last year, making it a total of $1682,18bn.

So far in 2008, the renminbi has appreciated 4.5 % to the U.S. dollar. If Chinese policy makers continue their present currency interventionist program, domestic inflation will get an additional shot of adrenalin, as foreign capital continues to flow into China.

Today’s floating exchange rate regime has created a vicious form of economic intervention that is getting more popular by the day. In the last couple of years we have seen many countries abandoning their currency pegs. Argentine abandoned their fixed exchange rate in 2002, devaluing the peso, and at the same time defaulting on their foreign debt. China cut their peg to the dollar in 2005 at the same time also devaluating their currency against the dollar. Next in line stands the Gulf coast countries which are planning to cut their peg to the dollar in the up coming years.

Fixed exchange rate regimes create serious problems as the country with the pegged currency are forced to import the monetary policy of the other country. Fixed exchange rates are nothing else than a price regulation, causing disruption of the supply and demand relationship in the currency market. More importantly it causes havoc in the economy, as the production process is altered.

The type of intervention that initially was referred to, is the exchange rate policy often adopted after a country has abandoned their fixed exchange rate. This is the policy of a weak currency regime where central banks literally drain the domestic market of foreign currencies, putting an upper lid on rates.

The logic of such a policy is flawed from the beginning as it artificially boosts goods exporting business and creates inflation, resulting in the business cycle. A good example of this ignorance is Argentine. Since they devaluated their currency, the peso has weakened against the dollar despite resent attempts of US to join the band wagon of weaker currencies. As the peso has lost international purchasing power, monetary inflation and price inflation has skyrocketed with official CPI close to double digits.

Supposedly, this has resulted in a GDP growth of about 9 % per year. Although GDP numbers have been adjusted for inflation, the misalignments of the Argentine economy is severe, and will eventually act as a downward force on growth. As exports are heavily subsidized, economic activity centers on this alleged profitable business, leaving the rest of the economy with lesser goods available to higher prices.

Real growth requires real investments. Only savings can produce future economic wealth. When a country is artificially holding exchange rates low they not only cause economic misalignment but also destroys incentives for foreign direct investments. Compared to Brazil who has followed a more conservative exchange rater policy since 2002, the percentage change in foreign direct investments in Argentine is estimated to only 12 % in 2007 compared to 84 % in Brazil.

The popularity of the “Argentine model” is undisputable as United States stand next in line to adopt the model, as deliberate actions are taken to devaluate the dollar with high inflation, money supply growth, and low interest rates, they’re lured by the fallacious logic of short term gain over long term pain.