Fed rate hike = stong $$ VS. interest rate parity/// contadiction???

I have just come across the concept of interest rate parity in my studies and found it very interesting. The basic form being FORWARD = SPOT[(1+domestic interest rate)/(1+foreign interest rate)] To not follow this relationship leads to an arbitrage opportunity so it should hold most of the time…so I see this as way to make a call on using what is known about interest rates to make a prediciton on where currencies will head or vise versa.

I was thinking about the general assumption that when the Fed starts raising rates the dollar will get stronger. This makes sense because essentially it will be the opposite of QE and money supply will get smaller. HOWEVER, according to interest rate parity (lets just look at the USD/EUR situation) if we raise interest rates, the forward exchange rate should increase… that means a depreciation of the dollar??? yes?

so if there are no holes in my reasoning( if there are please fill them in because I am very curious about all this), If interest rate parity is being violated by the dollar getting stronger on a rate hike then I would want to borrow in euros and invest them in the US when rates get higher because it would be an arbitrage situation. However, if interest rate parity is expected to hold then time to short the dollar because it is about to depreciate.

I must be oversimplifying. comments?

***also note that the interest rate parity uses domestic/ foreign for the forward and spot rate AND that CFA notation is the opposite of Forex so an increase in the forward rate is the uqivalent to a depreciation of the domestic currency.

Yeah, interest rate parity is only a theory. In practice, it is almost never true. The short term flows into currencies with higher rates is one example. Also, central bank intervention, demand for exports/imports, and individual country stability all distort the parity relationship.

Do funds commonly seek out this arbitrage when the parity is likely to be broken? If not, why?

I don’t have the L1 books in front of me but doesn’t interest rate parity assume equal real interest rates across all countries? In that case higher nominal rate implies higher inflation and hence a weakening currency.

If Fed ends up raising in September (which I still doubt), they will be raising nominal as well as real interest rates. Higher real rates will make US a more attractive place to invest, resulting in capital inflows, for which foreigners will need to buy USD, raising USD/EUR.

That’s the theory, anyway.

(Yes I am aware that to quote Damodaran, Janet Yellen doesn’t have a lever to raise or lower interest rates, only indirect market intervention etc etc; so “raise rates” is short-hand for “attempt to manipulate rates upwards.”)

Interest rate parity is one force that acts on the value of currencies and, consequently, exchange rates.

Supply and demand is another force that acts on the value of currencies and, consequently, exchange rates.

They generally act in opposite directions.

The first time you learn about covered interest arbitrage (after the WTF-just-happened-how-do-I-do-that-calculation? moment wears off), it seems like this magical incantation to predict currency exchange rates.

However, the arbitrage works on the following principle: You can enter a forward currency agreement, or you can build one yourself by buying and selling appropriate fixed income securities. The price should (within transaction costs) be the same.

If it isn’t: then you can buy or sell the agreement, then construct the same thing with the securities right now, and be guaranteed either 1) some profit today that you’ll never have to repay (if you sell the forward and construct the opposite position with the proceeds) or 2) no money today, but a guaranteed profit when the forward expires (if you buy the forward and construct the opposite). Whether you buy or sell the forward depends on whether you feel the market price of the forward is overpriced (sell) or underpriced (buy) right now.

It’s easy to think that this predicts the currency price, and that you’ve somehow constructed a crystal ball that predicts future currencies, but actually the future currency price is completely irrelevant to the outcome (which is the main reason it’s an arbitrage, rather than an ordinary risk-adjusted bet).

What this means is that the future currency price has no obligation to follow what the interest rate differential makes the arbitrage (i.e. future) exchange rate to be.

If you have some other way to make predictions about exchange rates, then the difference between the expected exchange rate and the interest rate parity implied exchange rate represents your profit potential. However that profit potential is not riskless, since it depends on how well your prediction on exchange rates works and how large that difference is. So you can still speculate on currencies, but it’s no longer an arbitrage.

If you don’t want to predict exchange rates or don’t have a reliable way to do it, then the covered interest rate parity pricing is not necessarily a bad first guess as to where exchange rates will go, however, other factors such as international trade and investment flows do move currency (the investment tends to be stronger than the trade in the short term at least). The ICAPM model uses forward implied rates as a basis for expected returns and then computes a beta that shows the sensitivity of returns to a departure from those implied or expected rate changes.

Presumably, the interest rate arbitrage is most useful as a profit making exercise when you have stressed governments needing to raise money but with a fixed exchange rate. Greece comes to mind. However, since Greece can’t revalue its currency, currency risk has been transformed into default risk, so there really is no such thing as a free pita.

As for the effect of interest rate hikes, there are so many feedback loops involved that it can be hard to predict, but basically there tend to be two main effects, and perhaps a third:

  1. Financial flows, which tend to affect the short term. If rates go up, more international investors will start to buy US treasuries because they pay better than before, and new people will become interested in them who weren’t interested before. The inflow of foreign demand will tend to push the dollar higher, and it will tend to happen quickly. This is why currencies tend to strengthen on IR hikes and weaken on IR cuts, but it’s only the immediate effect.

  2. Trade flows work the opposite. US goods and services will now be more expensive to foreigners, so there will be less demand for them. However, these differences tend to be felt over time, because trade in goods and services is not as instantaneous as pressing buttons on a trader’s desk. Plans have to be made to buy things, the cost differentials have to be researched, goods have to be shipped, etc… This plays out in the longer term (months and years). Because of the lag, people sometimes forget to associate this with the IR change, even if they are associated indirectly.

  3. IR hikes may cool the economy overall. This tends to push down exchange rates, but also is a long-term effect. Here the result can depend on whether the IR hike is happening in a growing economy that the central bank wants to keep from overheating (where the effect is pretty minor, and long term), or if the economy is contracting and the government is broke and needs to borrow more (like an austerity plan). In this case, the effect can be large and quite rapid.

So if there are rate hikes, the short term effect should be to strengthen the currency, but this effect will wear off after a while as the trade and economy-wide effects kick in.

You might think that this opens an opportunity to use covered interest rate arbitrage, but there is another kind of yield curve arbitrage that means that the change in expected interest rates have already been baked into the yield curve.

As a result, unless you believe that the currency will strengthen by substantially more or less than market participants currently expect, what you’ll discover is that the interest rates on the [US] treasury maturities you need to use take advantage of the currency hike in your time frame have changed such that you aren’t able to make an arbitrage profit. Before the expected rate hike, they will be at one rate, but after the expected hike date, they’re now higher.

If you think it’s going to be a bigger or smaller exchange rate change than the market implied rate, you can go ahead and do it, but it’s no longer a guaranteed profit. It’s just a bet with some level of risk attached.

All that said, it’s hard to say how things will move with interest rates already so pushed up against the 0 bound. The traditional logic is not obviously wrong, but there clearly is slack in what Ben Bernanke called “the transmission mechanism,” and so the first rate hikes might have a dramatic effect, but also might have no effect at all. At some point, rate hikes will have an important effect, and my guess is that Yellen and her Fed crew are going to be walking on eggshells trying to find where the point is where the interest rate changes start to have effects that measure up to traditional experience.

Thanks! This is the kind of depth and perspective I was looking to get on the subject. I still find the concept fascinating on account of it’s macroeconomic scope. It might not be a crystal ball but it is a catalist for speculation.

Back to my example of interest rate parity failure between the US and the EU given a Fed rate hike and a strenghtening dollar. This is a special case if I understand correctly. Normally when there would be more borrowing of euros to invest in the US to take advantage of higher rates + appreciating dollar, the rates in the EU would then increase as there would be a higher demand for capital. This would then erase the abitrage. HOWEVER, in this case we have continuing QE in the EU. Just as rates could be driven up, they will be driven back down as the ECB prints more money! I am naive when it comes to understading currency forward contracts and the cost of obtaining them but given that the cost is small, wouldn’t the situation developing between the EU and US present an ongoing arbitrage opportunity?

The different feedback loops are hard for my under-caffeinated brain to process while paying attention to my day job, so I’ll have to reread it when my mind is fresh.

However, it is true that in currency speculation, central banks that either choose to or are forced to depart from the traditional “manage inflation” mandate are where the opportunities to make money lie.

I don’t do currency stuff much anymore, since my current job is more real estate related than macro related, but a sensible approach to deciding where the opporunities are is to look at the 1-3 year segments of the yield curves in the US and Germany and compute interest rate parity implied exchange rates at each of the maturities on the curve.

The result is the market implied path for exchange rates.

Next, ask yourself - given what you know about the world - does that path seem reasonable to you, or is it wacky at a particular point in time? Or are there bets worth taking on departures from that curve. How long would it take for that bet to pay off, and is it worth waiting that long for that amount? How much capital does it require to make money on that bet?

You might also ask if the risk-return on those bets is better or worse than alternative bets, which likely include alternative asset classes like equities.

If you’re very deep, you might then ask if there are diversification advantages of currencies vs those alternative bets. One advantage is that currencies in developed markets tend to have low correlation with equity markets (the disadvantage is that there tends not to be a risk premium, so you can’t just be long a currency and expect to come out ahead in the long term the way you often can with equities)

So those are the layers of the onion that you would go through. The challenge with currencies is that you often have to have large capital allocations in order to make more than a tiny amount of money. This risk is reduced somewhat by the fact that these large allocations often offset each other, so that your net position of 100MM long USD is offset by 100MM equivalent short EUR in the hopes of making $2MM or so, but the consequence of that - aside from scary looking exposure sizes - is that any wacky tail event can have massive impacts. Pennies in front of a steamroller indeed, unless you correctly anticipate the tail event, which is the trade that made George Soros famous.