The Daily Update - PART II: An Augmented Model of Interest Rate Parity

Extract from Bob Gay’s piece ‘Policy Blunders and Currencies’

A simplified way of thinking about a directional (unhedged) carry trade is to presume interest rate parity will hold over an intermediate period with some extra bells and whistles for inflation and expectations. The objective of the carry trader is to find a currency with a higher yield than elsewhere and with a good chance of remaining that way for long enough to earn a significant arbitrage. In short, the arbitrageur is looking for an interest rate differential that is likely to persist. Although interest rate parity argues that the rewards of a significant interest differential soon will be arbitraged away by an adjustment in the currency, in practice differentials do persist, sometimes for long periods, because a country is pursuing domestic policies that diverge from those elsewhere for whatever reason. Oftentimes this occurs because its economic cycle is out of sync and hence calls for different policy settings.

The time horizon is critical in determining what matters in this framework. Over a short horizon of three to six months, interest rates matter in attracting capital flows that supplement financing for current account balances. Deficit countries depend on these flows, which can be flighty, and hence must maintain higher real interest rates. Surplus countries only need to offer sufficient yield to keep these fluid capital flows at home. Other short-term influences include surprising economic data or political events that may portend changes in monetary or government policies, large international transactions, and tax changes affecting offshore cash holdings of multinational companies. Often these factors create more noise than trends unless the interest rates differential is expected to persist due to asynchronous policies and economic cycles.

As the time horizon lengthens, the policy mix takes on greater importance. In recent years, for example, the Japanese yen was used as the funding currency for many carry trades because there were no signs of renewed growth or inflation that might persuade the BoJ to exit its super aggressive monetary stance and hence little chance of narrowing the differentials with higher yield currencies abroad. A host of other factors come into play. After 12 to 18 months, for example, inflation differentials plus whatever affects in expectations of those differentials begin to make a difference.

A longer time horizon translates into a longer list of influences on expectations and future real rates as well as other cross border flows. At some point, the cumulative difference between domestic economic fundamentals and those aboard begin to take a toll on the exchange rate, for better or worse. Given enough time, changes in prices of key commodities, in competitiveness and current account balances, technology transfer, and the relative strength of domestic demand at home and abroad tend to outweigh the monetary conditions that encourage fleeting ‘hot’ money flows.

Over much longer periods, the cumulative effect of these fundamentals are reflected in a country’s foreign assets and liabilities, which tend to dominate the noise embodied in short-term volatility and oftentimes even policy disparities that are expected to persist for years. Namely, currencies of countries with large net foreign assets are much less dependent on hot money flows than large debtor countries. Creditors can weather a storm of adversity or price shocks, whereas debtors are dependent on foreign monetary inflows to fill the hole in their financing of their net foreign liabilities. Creditors’ currencies tend to appreciate while those of heavy debtors tend to depreciate. In short, a country’s initial position in terms of domestic savings and net foreign assets makes a big difference for currency valuations, especially in periods of crisis and when countries make major policy blunders that affect capital flows.

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