The World's Major Currencies Have Lost a Fundamental Anchor
The world's major currencies are adrift after decoupling from one of their most important fundamental drivers—interest rate differentials on short-term sovereign debt.
"Basic economic theory holds that interest rate differentials are responsible for changes in exchange rates over time," wrote analysts at Bespoke Investment Group. "Currently, a number of global FX pairs are seeing sharp divergences between recent FX differentials and their spot levels."
The relative value of two currencies tends to track the two-year yield differential between the sovereign debt issued by those nations.
To paraphrase Chronus Futures Management Chief Market Strategist Kevin Ferry, foreign exchange rates are the reflected light, not the sun. Put differently, in markets, foreign exchange rates are the tail, and interest rate differentials are the dog.
As a simplification, imagine Country A and Country B have an exchange rate at parity, but short-term interest rates in the former are 25 basis points higher than in the latter. All else equal, market participants would be incentivized to sell Country B's currency and use the proceeds to buy short-term debt in Country A. This dynamic would put upward pressure on Country A's currency relative to B's, effectively having it better reflect the available yield premium.
"Interest rates are like an anchor on foreign exchange because they create arbitrage-free conditions," said George Pearkes, analyst at Bespoke Investment Group.
The U.S. dollar, British pound, euro, and Japanese yen are all currencies Bespoke highlighted as displaying some particularly unusual price action in foreign exchange relative to rates.
"Our take on this: global financial markets are not responding to fundamentals. Dislocations across interest rates, equities and credit are creating huge risk aversion," wrote Bespoke. "In our view, markets are not behaving 'normally' and the breakdowns in 'rule of thumb' FX interest rate differentials are a good way to think about how disjointed markets have become."
While these divergences are certainly noteworthy, it's worth pointing out that the two-year nominal yield spread is a helpful proxy but not the be-all, end-all for currency valuations.
Differences in spreads at various parts of the curve, the use of forwards as opposed to spot prices, and real rate differentials all factor into relative valuations in foreign exchange.