Do high interest rates make a currency stronger? 

Conventional wisdom in recent times has brought a correlation into most peoples' minds between interest rates and the strength of a currency. Nowhere has this been clearer than in the United States, where in the past two years, the dollar has seen repeated injections of foriegn value as the Fed continues to hike rates. Conventional reasoning goes as follows: If interest rates in a given currency are higher than at home, investors will be more likely to sell their local cash and buy bonds in the higher-paying brand. This will in turn stoke demand for the higher-interest-rate currency on the forex markets and raise its value. However, too many people , even serious traders and policymakers, have confused short term investment demand with real structural strength. They have forgotten that the whims of currency and bond traders seeking a place to park a few billion for the next 3 months are not the blood and muscle of a real economy. It is entirely true that in large developed economic zones with highly liquid financial markets do indeed exhibit this promiscuous tendency, but the flow of manufactured goods and physical resources, the things which ultimately give money its value, tend to follow slower, deeper trends instead. In the short term, it is true- higher yields on debt will attract investors, which will bost demand for currency. In the long term, however, rising interest rates are actually often bearish for a currency. Here's why. Fundamentally, interest is a speculation on the expectations of the future value of borrowed money and what is done with it in the meantime. It's a bet on risk. At the very bottom, lenders expect that the real value of the sum repaid will yield a profit over the real value of the sum loaned, at the time of repayment and lending respectively. The value of a repaid loan has two important aspects: its nominal face value, which is an amount of currency traded in real time, and its real value, which is in some cases very hard to quantify, but ultimately is the matter of what can one buy with that sum, at that time. Thus, there are two components to the interest rate: the cost of the risk in the loan in constant (real) value, and the cost of the risk of the depreciation of the principal's real value over the period. One is a bet on the performance of the borrower, and the other is (in today's markets) a bet on the purchasing power of fiat currency over time. Low interest rates imply that money is not expected to produce significant nominal returns, and lenders are willing to part with it on the cheap. This might be because they anticipate strength in the value of the money, and thus don't need to price into the loan the lost value in the money over its duration, or because there is too much liquidity and heavy competition to lend (even low interest rates pay better than cash sitting in the vault), which can happen when the economy is sluggish and there is a lot of cash chasing very few investment opportunities, or because the economy is running so smoothly and uneventfully that the risk in lending is very low (though 'stable' implies 'no growth' and thus means that things might be humming along, but theyre also stagnant. Industrial economies are funny like that). High interest rates, however, demand that currency find a way to multiply itself much more aggresively. They reflect a climate of higher percieved risk in lending. Higher interest rates inherently carry the attitude of suspicion on borrowers' and lenders' parts alike. High interest rates are a signal of poor confidence in at least some part of the life-cycle of a loan. Rising interest rates can be an indicator of economic strength if they imply that the productivity of capital has risen- not only can an individual borrower afford to pay back more, but there is also higher competition for capital and bidding up of its price in the market. This is if the return on investment component of the interest rate is what is rising. However, rising interest rates can also be an indicator of fundamental weakness in the value of a currency, and reflect an increase in the depreciation risk component instead. The cost of capital in real terms could be considered to be the real interest rate, whereas the spread between the real interest rate and the nominal rate is that second component, the cost of inflation being priced into the cost of borrowed money. If the economy is stagnant, and the money supply is expanding faster than real GDP, then there is a necessary dilution of the currency issue with respect to purshasing power in the physical economy. Interest rates rising in nominal terms without any confirmation from other economic indicators of growth (employment, wage pressure, productivity, savings, distribution of wealth, etc) is a sure sign of currency debasement in progress and is an indicator of exactly the opposite from the short term forex moves: The currency is sinking in real value, not rising. It is actually a good indicator of worldwide economic health to observe where capital is allocated and how it is priced. In a steadily growing economy, productive enterprises compete for capital to expand or establish their operations, and return a greater value of output product than was their capital investment. In a time when there is enormous opportunity for growth, the price of capital can get quite high, because it takes real resources to sink into the exploitation of new sectors of the playing field. Ultimately, that capital is real physical stuff and labor in the present, and too hot a competition for it leads to rising money prices and higher real interest rates. In an environment where the real opportunities for growth are few, there is much capital chasing few good investments, and the price of money is cheap. More and more investment takes the form of reallocating existing wealth instead of producing new wealth. During such an environment, real interest rates are extremely low, though nominal rates might be quite high. One very common scheme to transfer wealth without creating new wealth, one which every single fiat currency has succumbed to sooner or later, is the inflation of money supplies beyond the economic growth rates and the proximity effect it offers in the reallocation of wealth. Those closest to the issuance of new currency have the greatest gain from its diluting effect on the rest of the money supply. Even in good times, this tap is always available to open and pour out new money into the hands of governments and banks. In hard times when there is little to be gained from actual enterprise because the arena is saturated, this mechanism is irresistible. In the modern economy, there is not an isolated arena standing alone from the rest of the globe. Economic activity and performance is a global phenomenon and capital markets are unified and worldwide. Individual currencies move against one another as wealth moves around the globe, but no currency is standing still- one moving ahead of another does not really imply the apparent shift in wealth from one denomination to the other, but rather only reveals the momentary relative speeds. One moving ahead could just as easily mean both falling behind with one falling behind faster. When we see high interest rates and watch as the bond traders chase yields and exchange rates move in favor of higher-interest currencies, let us not forget the difference between real and nominal interest rates. And on the subject of a 'healthy' economy... Let there be no illusions- an industrial economy is not a healthy beast. It is by nature an unstable process, one where unending growth is necessary to postpone severe collapse. An industrial economy is an exercise in unsustainability under pressure: all competitors are locked into a race to consume a fixed pool of resources faster than the others, to prevent the others from getting the resources first. In the process of running this race, the contestants have to pull out every stop, try every trick, and sell as much of their future as necessary to stay in the running in the present. The name of the game is postponing the reckoning so it falls on someone else's tab. An industrial economy is the ultimate pyramid scheme, but while the going is good, we call it economic growth. What does this mean for gold? Just look at the price! A strong dollar in the forex market does not mean that the dollar is strong!
This file copyright 2008