Interest Rate Differentials Drive the Currency Markets

Even though this month has been one of the most volatile with the Japanese earthquake and wars in the Middle East, the currency markets are settling back into a familiar pattern. Interest rate differentials are again in the driver’s seat, and “risk” trades are riding shotgun, forcing safe haven trades into the back seat.

The best performing currencies in the past 24 hours were the commodity currencies of New Zealand (NZD), Canada (CAD), South Africa (ZAR), and Australia (AUD). The worst performer? The Japanese yen (JPY), which is now trading back where it was at the beginning of the year. The combination of G7 intervention and a move back into the carry trades have worked against the yen.

Interest rate differentials are helping to keep the euro (EUR) well bid in spite of another round of downgrades by S&P. European prices rose the most in more than two years in February, and kept the inflation rate above the ECB’s 2% limit for a third month in a row. ECB leaders are sounding more hawkish, and an interest rate increase is certainly looking more likely at the next meeting. Standard and Poor’s downgraded the debt ratings of both Greece and Portugal, bringing focus back onto the ongoing European sovereign debt crisis.

On this side of the “pond,” the data don’t support an early exit from QE2 and interest rates will likely remain near zero. Consumer confidence dropped from an adjusted 72 to just 63.4 in March, as fuel prices surged to the highest level in more than two years. We don’t have much scheduled in the way of data releases in the US today, and will have the weekly jobs numbers and factory orders on Thursday. The markets will be concentrating on the monthly jobs numbers, which are scheduled to be released on Friday. These monthly numbers are expected to show a slight improvement from last month, but the risk is pretty great that they will disappoint. Bernanke and his boys over at the Fed have used the poor jobs data as a reason for the quantitative easing, so a disappointing number will only confirm our expectations of a full QE2 and raise the possibility of a QE3!

Unlike the US Fed, Norway’s central bank has a keen eye on inflation. Norway’s central bank governor Øystein Olsen said a strong currency should help keep a cap on inflation. The Norges bank has kept interest rates unchanged since May of last year, but has signaled it may start raising earlier than previously indicated as inflation continues to be a worry. Policy makers are looking to raise rates in either May or June, and any interest rate increase would certainly help the krone (NOK) which has been among the best performers versus the US dollar this year.

The Brazilian real (BRL) was one of the best performing currencies versus the US dollar over the past 24 hours in spite of the government’s attempt to stem the rise of their currency.

I had a very interesting conversation with a WorldMarkets investor who had just returned from business in Brazil, and wanted to share his views on what is currently happening in that country. He informed me that Brazil instituted two separate measures designed at cooling off what is possibly an overheating economy. The first measure was a new 6% tax on international bond sales and loans made by foreign banks to Brazilian companies. This was designed to try and keep foreign banks from flooding the Brazilian economy with loans and cheap financing. This move was discussed by Brazilian leaders a few weeks ago, and looks to be a good way to try and keep Brazilian companies from becoming over-extended and to protect the economy from a flood of foreign capital. I have never been a fan of intervention, but this move by Brazil seems to be an acceptable way to try and stem the flow of foreign capital into their markets.

The second measure was not as widely reported, and involved an increase on the tax on foreign purchases by Brazilian citizens. I couldn’t find too much information on this tax, but a Pfennig reader let me know that the tax was increased from 2% to 6% and only applies to credit transactions made by Brazilian citizens traveling overseas. But neither of these measures seemed to work, as the Brazilian real continued to climb overnight.

The kiwi was back on the rally tracks overnight as New Zealand posted its first trade surplus in eight months in February. Exports outpaced imports by NZ$194 million from a revised NZ$3 million deficit in January. The higher exports should help New Zealand’s economy recover from last month’s earthquake. New Zealand’s central bank went against the trend and lowered rates last month over fear of an economic slowdown due to the catastrophe in Christchurch. But the surprisingly strong trade surplus may have them reverse course on rates, or at least that is what currency investors are now thinking. The kiwi is one of the favorite carry trade investments, and higher rates in NZ would certainly help propel the currency higher.

Both the Aussie and Canadian dollars were higher overnight on interest rate expectations. According to RBC, the loonie will strengthen to a 3-year high of $1.05 by the end of 2011. An RBC currency specialist cited expectations for interest rate increases by the Bank of Canada in a March 28 interview. A report tomorrow is expected to show that Canada’s GDP matched the fastest pace in almost a year.

Australia’s dollar rose to another record yesterday versus the US dollar as investors were attracted to higher rates and the positive global economic outlook. A report showed that Chinese manufacturing expanded at a quicker pace than economists had predicted. And since China is Australia’s largest trading partner, and New Zealand’s second biggest export market, the higher growth will continue to rally both of these commodity based currencies.

Recap: Interest rate differentials are back in the driver’s seat, and the high yielding currencies are benefiting. The yen is down again, and both the Aussie dollar and the kiwi were higher. European inflation came in higher than expected, and the ECB is expected to be raising rates. Brazil is trying to cap the appreciation of the real with higher taxes, but it doesn’t seem to be working. Commodity currencies are king.

Chris Gaffney
for The Daily Reckoning