Posts Tagged ‘Interest Rates’
What do real interest rates tell us about the U.S. dollar?
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.
