Most commentators assume that the only thing currently
keeping the USD afloat is high interest rates. While attractive rates have certainly encouraged an inflow of (risk-averse)
foreign capital in the short term, they may ultimately be harming the currency in the
long-term. In fact, the economic law of interest
rate parity dictates that currencies and interest rates should move away from
each other in the long term. Stated
differently, high interest rates should imply a less valuable currency. Since US rates are among the highest in the world, the USD should decline in the long term in order to compensate US investors in foreign securities for the lower risk-free returns they are implicitly accepting.
The reasoning is simple enough: since the advent of currency
futures, traders have been able to speculate on future exchange rates. In order for futures to be priced fairly
(such that arbitrage is impossible) the difference between a currency’s current
value and its implied future value should perfectly equal the difference
between domestic interest rate levels and international interest rate
levels. In the case of the US, bets on
the USD made during the recent period that US interest rates have exceeded European
and British interest rates, must have been predicated on a declining USD in the future,
which is now the present.
Original post by Jimmy Atkinson and software by Elliott Back
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