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In 2016, the ECB has lowered interest rate to 0%. Some people assume that within the next few years, the ECB will increase the interest rate.

How would that most probably affect the EUR/USD exchange ratio?

Or more generally and abstracting other factors, how does the ECB/FED interest rate usually affect the EUR/USD ratio?

2 Answers 2

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If you're talking current exchange rate, it won't. It will affect future exchange rates as the euro deflates because of interest rates.

In general, the future expected exchange rate is the current exchange rate times the ratio of the numerator's interest rate to the denominator's interest rate (adjusted for timeframe).

Or mathematically:

f(EUR/USD) = EUR/USD * (1+r(ECB)) / (1+r(FED))

So as the ECB rate increases, the future expected exchange rate will increase (assuming a stable FED rate).

That said, these expected rate increases are ALREADY priced into future exchange rates, so unless you think the rate will increase but the market does not, you CANNOT profit off of this in the FX market.

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  • How is EUR/USD quoted in your example?
    – AKdemy
    Jun 27, 2023 at 23:44
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By market convention EURUSD is quoted in terms of how many USD one needs to buy one EUR. For example, if the exchange rate is 1.2, you need 1.2 USD to get one EUR. If the EUR interest rate is higher, the expected exchange rate will decrease to some value below 1.2. This in turn will result in an appreciation of the USD relative to the EUR.

A common misconception is that higher interest rates will lead to an appreciation in the future, but in fact, theory claims the opposite: any higher interest in one country will be offset by a depreciation in that countries currency so that an investor will be equally well off. In other words it doesn't matter where you invest.

Part of the explanation to that puzzle is that any news (changes in market data) will be priced in instantaneously. If higher interest rates in the EUR area, relative to the USD make EUR investments more attractive, you can expect an appreciation in the EUR. However, that already happens as soon as rates (expectations) change.

Given market data (spot and rates are known), FX forwards are priced as shown in the wikipedia article about covered interest rate parity.

enter image description here

No matter what you do, returns from investing domestically are equal to the returns from investing abroad. This works because you enter a forward and fix that rate that guarantees no arbitrage. Details, and an example with actual market data from Bloomberg, can be found in this answer.

In terms of expected spot (E(S)), the story is more nuanced. The so called uncovered interest rate parity is defined like this:

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or rearranged:

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If you think of EURUSD now (how many USD per EUR), sticking to the Wikipedia example above, if current spot = 1.273, if the EUR interest rate is 4.4% and USD 3.2% you get (for a year), the value of

enter image description here

In other words, you need less USD per EUR - the USD appreciated, EUR depreciated.

That said, there exists a widely used strategy called the "carry trade". For the carry trade to work, this cannot be the case (higher interest currencies do not depreciate as much, on average). It is a successful strategy, but very risky because there is a tendency for this depreciation to actually happen - often rapidly during terms of crises. That is why there is the saying that with a carry trade you walk up the stairs (small steady returns) and go down the escalator (large sudden losses).

Many people unfamiliar with the FX market cannot understand why a higher interest rate should lead to a depreciation. Intuitively, it seems sensible to invest in the higher yielding currency. However, that would mean you would gain twice, on the interest rate, and the appreciation. Another way to understand why this relationship makes sense, is to look at the differences in inflation rates. The image below is from FRED using FredApi in Julia.

enter image description here

Turkey has a higher interest than the US (currently 15%) but still, the Lira depreciates steadily against the USD. The reason is higher inflation.

Empirically, FX is also a lot more volatile and random than this relationship suggests.

TL;DR

From a theoretical point, this is why "overshooting models" were developed. These are part of the stock approach to FX modelling and consist of flexible and sticky price monetary models which combine capital markets, goods markets and money markets. Sticky price monetary models are also known as overshooting models, initially designed by Dornbusch (1976).

In terms of forecasting (what might to be your ultimate goal?), neither of these models perform well or can be used. Kenneth Rogoff and Richard Meese received an incredulous reaction to their now-famous paper showing that random-walk (RW) forecasts outperform economic models of exchange rates. Reactions were along the line of “You just cannot possibly have done it right” or "the results are obviously garbage". Turned out they were correct. Rogoff makes an interesting point in some later paper. If money supplies are hard to predict, then one should not blame the models if exchange rates are hard to predict. It is unforeseen news that matters. However, as Rogoff further stated, their finding was even more extreme. They tested predicting the exchange rate in one year, given the information about what money supplies, interest rates, and outputs are going to be in one year. However, even in this case, no economic model beat(s) the RW. For anyone interested, this answer on quantitative finance SE contains a lot of links to theoretical concepts around FX price determination.

If EUR/USD in the other answer refers to USDEUR (how many EUR one needs per USD), I would say it would have been worth noting that this notation is against market convention.

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