Rethink likely on foreign exchange forecasts

Rethink likely on foreign exchange forecasts

By Peter Garnham in London

Published: January 27 2008 22:32 | Last updated: January 27 2008 22:32

In the notoriously difficult art of forecasting foreign exchange movements, traders have been able to rely on one key relationship in recent years. The higher a country’s interest rates, the stronger its currency typically became as investors sought greater returns from yields.

Now traders may have to rethink. Foreign exchange markets could be on the verge of big shift, some strategists believe. The currencies of countries that cut interest rates could be rewarded with higher exchange rates. The pattern of currencies benefiting when central banks raised interest rates and weakening when monetary policy was eased held largely true last year, when cuts from the US Federal Reserve pushed the dollar down to record lows.

However, last week’s emergency 75 basis-point cut in the benchmark Fed funds rate has not so far led to significant dollar weakness. Mansoor Mohi-uddin, chief foreign exchange strategist at UBS, said: “Investors are starting to ask whether central banks that proactively cut rates to bolster growth will now see their currencies rally and whether those that don't will see their currencies weaken.”

Indeed, analysts said the hawkish tone of the European Central Bank, which last week described hopes of a cut in eurozone interest rates as “wishful thinking”, might eventually damage the euro.

“The market is going to come round to the view that the ECB is too hawkish,” said Gavin Friend at Commerzbank. “They are boxed in and it is going to hurt the economy.”

The last time currencies traded consistently in this way was after the end of the dotcom bubble in 2001 and 2002.

However, from 2003 to 2007, the boom in the world economy, low market volatility and predictable interest changes encouraged investors to take on increasing amounts of risk. In the currency markets, this led to investors favouring carry trades, in which the purchase of riskier, higher-yielding assets is funded by selling lower-yielding currencies. However, the global credit crunch sent risk aversion sharply higher.

Mr Mohi-uddin said this had not yet led to a reversal of the current positive correlation between interest rates and currencies, but added: “We are not there yet, as we were in 2001, but the markets don’t seem far from this tipping point.”