Interest rate differentials
In addition to growth, currencies are also highly correlated with interest rates and particularly relative interest rates (or interest rate differentials). Indeed, in recent years, this has become a key determinant of trends in currency markets.
Interest rates are the ‘price' of money, and high interest rates encourage global capital to flow in to an economy, boosting the value of its currency. Currency markets look at both short term ‘cash' rates as well as longer term bond yields. Rising interest rates - especially relative to interest rates elsewhere - indicate a stronger currency and vice versa. The most recent example of this is the strong appreciation of NZD/JPY in recent times, with Japan interest rates close to zero but NZ cash paying over 8%.
In major economies, the central bank sets the cash rate, which anchors the longer end of the yield curve. Central banks use the cash rate as the key policy tool to manage the economy, aiming to contain inflation and extend the business cycle. In most cases, central banks target ‘low and stable' inflation, with many running explicit targets for inflation. Simply, when inflation is rising, monetary policy is tightened by raising the cash rate, and vice versa. As a result CPI data is critical.
However, policymaking is rarely this simple, as the central bank attempts to pre-emptively move against future inflation pressures. As such policymakers look at a whole range of factors - including economic growth, wages, the degree of resource utilisation, unemployment and inflation expectations - and, given this, currency markets carefully monitor policy speeches by central bank members (such as Fed Governor Bernanke).
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Source: LatitudeFX Limited
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