domingo, 11 de enero de 2015

domingo, enero 11, 2015
The dubious relationship between yields and exchange rates

Matthew C Klein

Jan 06 18:23

Professor Krugman has a new post that tries to explain why nominal US sovereign interest rates are higher than nominal euro area bond yields. Much of the piece is useful, especially since he is right that credit risk has nothing to do with the differential between German and American borrowing costs.

Higher US rates are instead the result of differences in real rates and inflation expectations between the two countries. But we part ways with Krugman when he makes this argument in the context of expected changes in the exchange rate between euros and dollars:
The crucial point here is that German bonds are denominated in euros, while U.S. bonds are denominated in dollars. And what that means in turn is that higher U.S. rates don’t reflect fear of default; they reflect the expectation that the dollar will fall against the euro over the decade ahead.
The really questionable bit comes later:
The relative strength of the US economy has led to a perception that the Fed will raise rates much sooner than the ECB, which makes dollar assets attractive — and as Rudi Dornbusch explained long ago, what that does is cause your currency to rise until people expect it to fall in the future. The dollar is strong right now because the U.S. economy is doing better than the euro area, and this very strength means that investors expect the dollar to fall in the future.
We don’t understand this logic. If people think the dollar will depreciate against the euro in the future they should sell dollars and buy euros today, which would cause the dollar to fall against the euro. Yet the dollar has been rising as the yield gap has widened.

In fact, there has been a reasonably strong relationship between the difference in German and American sovereign borrowing costs and the EURUSD exchange rate, where an increase in relative UST yields goes hand in hand with an increase in the relative value of the dollar:


(Source: Bloomberg, author’s calculations)


It’s possible that the confusion comes from the fact that the exchange rate quotes you will hear when you call up your friendly neighborhood currency dealer will vary depending on when you want to actually exchange dollars for euros. If you want to swap currencies today, you will get the rate that pops up in the news (about $1.19 per euro as of pixel time). If you want lock in a rate today but wait for ten years to actually hand over your dollars for euros, you will get a different rate where the euro is worth relatively more than it is now, precisely because interest rates in the US are higher than they are in most of the euro area.

And, in fact, a thing you sometimes hear in FX is that a currency is “priced to depreciate” or “priced to appreciate” by a certain amount based on short-term yield differentials. In particular, lower-yielding currencies are “priced to appreciate” against higher-yielding currencies, while high-yielding currencies are “priced to depreciate” against low-yielding ones.

This doesn’t mean, however, that people who trade currencies go around betting that low-yielding currencies will rise in value relative to high-yielding ones, as Krugman implies. If anything, traders tend to prefer selling low-yield currencies while buying high yield-currencies.

Interest rate differentials have basically no predictive power for exchange rates. People like Eugene Fama were writing about this years before we were born, and even he wasn’t new to the subject.

Economists have long had a hard time explaining movements in currencies. Here is a 1982 paper by Ken Rogoff on the failure of academic models, h/t Tony Yates. Strategies that aren’t “supposed” to work (selling low-yielding currencies in exchange for high-yielding currencies and momentum) have proven to be remarkably profitable. No one seems to have a great explanation as to why.

For what it’s worth, one convincing argument we have heard is that many of the biggest players — tourists (not macro tourists), nonfinancial companies engaging in cross-border M&A, and central banks that intervene in the markets to improve the competitiveness of their exports, for example — aren’t trying to maximise trading profits but have other agendas that are difficult to capture with models. The good news for traders is that if you can identify what these players are going to do and fade them, you can make money. But knowledge of economic fundamentals alone won’t get you very far.

So what explains the FX jargon?

It’s easiest to think about this with a simple example. Imagine a world where the 1-year risk free interest rate in the USA is 5 per cent and 0 per cent in Japan, and that the current exchange rate is 100 yen per US dollar. If I start with $1 and 100 yen currency and invest my money into risk-free accounts in each country, then after one year I will have $1.05 and 100 yen. Put another way, today’s market pricing implies that my 100 yen will buy more dollars in the future than they do now.

Now, none of this tells us anything about what the actual dollar/yen exchange rate will be after a year. However, it does tell us that anyone who trades currency forwards should account for the differences in interest rates that you can lock in today to avoid handing free money to your counterparty.

To use the example above, the 1-year forward exchange rate should be about 95.3 yen per dollar (100/1.05). If you call up your friendly neighborhood FX dealer and he says that he will agree to buy your future dollars at the rate of 100 yen then you should take the deal in a big way. Specifically: borrow a lot of yen for a year at basically no interest, find another currency dealer to immediately convert those yen into dollars at the rate of 100 yen to the dollar, lock in a 5 per cent return on your dollars, and then wait for a year.

After a year, you would ring up your friendly neighborhood currency dealer, give him the dollars you agreed on, get back enough yen to repay your debt, and then have fun with the leftover dollars you made by doing nothing. Those leftover dollars effectively came from your friendly neighborhood currency dealer, unless he found a chump to take the other side of your trade and offload his earlier misquote. To avoid this outcome, FX desks give quotes for future exchange rates that are different from spot exchange rates.

The important point here is that none of the participants needs to have a view about what the future dollar/yen exchange rate will be. Rather, they are simply using today’s yield curves to calculate today’s forward curve for the exchange rate. (Incidentally, the same logic applies to futures prices of commodities and financial assets. The difference between the current price of crude and the prices implied by futures tells you basically nothing about what will actually happen to the oil price, although it can tell you interesting things about the cost of physical storage.)

Just as the difference between German and American sovereign borrowing costs tell us nothing about default risk, neither do they tell us anything meaningful about future exchange rates, much less market expectations of future exchange rates.

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