Intro: Changes in real interest rates are the key drivers of currency movements. In the short term they impact returns on speculative investment flows, while in the long term they determine total return performance.
Real interest rates are at the heart of currency movements in both the short term and the long term. Their importance cannot be overstated. Indeed, any currency moves that are not driven by changes in real interest rates or real bond yields should be treated with extreme caution as they tend to be transitory in nature. Not only do higher real interest rates reward short-term currency investors and therefore attract speculative capital, they also reflect higher real GDP growth which is crucial for long-term currency strength.
In the short term, it is the trend of real interest rates that drives currencies. If real interest rates are rising in a particular country relative to another, even if they are lower in absolute terms, that currency will face appreciatory pressure. The reason for this is that currency markets move in response to marginal changes and even a slight improvement in real rates, even if they remain deeply negative, is a positive marginal change.
In the long term, it is the absolute level that matters. If a country has a higher real interest rate relative to another, that the currency will tend to outperform (in total return terms. i.e. considering interest rate gains) because whatever downside pressure arises from inflation will be more than offset by the higher nominal interest rate.
For example, imagine two countries; one with 2% inflation and 4% interest rates, resulting in 2% real interest rates, and the other with 0% inflation and 0% interest rates, resulting in 0% real interest rates. The first country should be expected to experience 2% depreciation in order to maintain its value in real terms amid higher inflation. However, this 2% nominal depreciation should be more than offset by the fact that interest rates are 4% higher so in total return terms the currency should outperform.
Now, assume that in the first country real GDP growth is stronger as reflected by the fact that real interest rates are higher (see ‘Drivers of Government Bond Yields’). If this is the case then we should expect to see the currency weaken still in nominal terms due to the higher inflation rate, but by a lesser extent to reflect the fact that it is experiencing higher real GDP growth. This is because higher GDP per capita ‘justifies’ a stronger currency (see chart). So, we should expect to see total return gains in excess of the 2% real interest rate differential.
If the central bank of the country in focus decides to cut interest rates from 4% to 3% without any change in the inflation outlook so real interest rates fall to 1%, then we should expect to see a short-term weakening of the currency to reflect the shift lower in real interest rates. We should still expect to see long-term currency outperformance in total return terms, but to a lesser extent reflecting the lower real interest rate advantage.
Default Risk is an Additional Short-Term Currency Driver in Emerging Markets
In the long term, both emerging and developed market currencies respond the same way to real interest rates, but in the short term there is an additional factor driving emerging market currency performance. For emerging markets, particularly ones with high levels of external debt, changes in real interest rates and bond yields tend to reflect shifts in default risk (see ‘FX: The Importance of Real Interest Rates‘). A higher risk of default, as measured by credit default swap spreads (CDS) will mean investors require a higher real interest rate to compensate for the added risk, and vice versa. Even though default risk pertains to foreign currency rather than local currency debt, history shows that spikes in default risk on external debt routinely result in investors requiring a higher real yield on local government debt. We use risk-adjusted real yields to ascertain to what extent real yield changes are being driven by default risk versus changes in real GDP growth expectations.