Currencies and the race to hike rates

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Currencies and the race to hike rates

As major economies strain under cost of living pressures, central banks are getting more aggressive on interest rates. The difference in interest rates from country to country, otherwise known as interest rate differential, has a high bearing on currency performance and volatility. Here, we explain the current state of play and what to watch in the coming months.To get more news about EightCap易汇, you can visit wikifx.com official website.

At the recent G7 finance leaders meeting in Germany on May 20, the head of the International Monetary Fund warned that more inflationary shocks were likely, and expressed concern that central banks might not be able to get inflation down without causing recessions.1
The worrying element for central bank policymakers is that these are rises in core inflation, a measure that strips out the inflation linked to food and energy, which is usually more volatile, demonstrating that the problem is far deeper than supply issues due to the pandemic or the war in Ukraine.

By altering interest rates central banks can impact spending and its effect on how much things cost.

Once central banks raise rates, the increased cost of borrowing is then passed on to consumers. Increased mortgage payments encourage saving in favor of spending and make it more expensive for businesses to invest. Higher rates also tend to depress the value of other assets like equities and property, reducing consumers’ perception of wealth, which makes them less confident about discretionary spending.

But the tricky balance central banks must get right is not causing people to cut spending too much, otherwise it will start to reduce business investment which would push up unemployment, and potentially cause a recession.Generally, a currency tends to appreciate relative to a peer as the gap between interest rates widens. As interest rates go up, investors buy holdings in the currency where the yield is higher, and the increase in demand sees the currency gain in value. On the other hand, as investors sell off lower-yielding currencies, the drop in demand decreases currency value.

That has certainly been the case with the US dollar versus the euro this year. For the past 20 years the Euro has been higher than the USD and the currencies were last at parity in 2002.

As noted earlier, the US Federal Reserve has been raising interest rates and flagging more aggressive rises to come. By contrast, the European Central Bank (ECB) has continued with its dovish (accommodative) stance, which means the gap between US and European interest rates has widened and will likely widen further. Furthermore, its economy is more directly affected by the war in Ukraine, and, as a net energy importer, more susceptible to its growth prospects being hit by supply challenges.

That has caused the Euro to slide as much as 7% against the USD this year, although recent statements by the ECB that it will “normalize” monetary policy4 have seen that slide reverse slightly.