By Economic Strategist, Hottinger Investment Management
One of the ideas that lie at the heart of the theory of economics in a world in which capital can flow seamlessly across borders is that there is only one global price for money. The price of money is the real interest rate; it is the amount of real economic resources that have to be given up to borrow a sum of money or received for lending it. Since investors can move the capital freely, so the theory goes, any differences in real interest rates in different countries, excluding the premium that reflects country and market risk, will be traded away.
Another theory is that of ‘uncovered interest parity’ (UIP) and it describes the relationship between the difference in interest rates between two reference countries and the movement of their exchange rate pair. It is an arbitrage relationship that states that investors accommodate different nominal interest rates between states by acting in the foreign exchange market to prevent any one country offering more attractive terms than another. One country can only offer higher interest rates in their currency than another if investors expect that country’s currency to depreciate over the period of the investment. If that country continues to offer greater interest rates adjusted for expected exchange rate movements, money will pour into it until the incentive to do so disappears.
This idea is best demonstrated by way of an example. Suppose that the current (Year 1) exchange rate between the pound and the dollar is parity or $1:£1 but that the US offers a 3% interest rate in dollars and the UK offers a 1% interest rate in pounds sterling.
| Year 1 (Current) | Year 2 | |
| US (3% interest rate) | $1.00 | $1.03 |
| UK (1% interest rate) | £1.00 | £1.01 |
| Exchange rate | £1:$1 | $1:£0.98 or £1:$1.0198 |
UIP theory says that there should be no opportunity to profit from this difference because the exchange rate adjusts from $1:£1 to $1.03:£1.01. This means that the dollar depreciates, or becomes less valuable, over the period and correspondingly the pound appreciates. The new theoretical exchange rate is $1:£0.98. Thus the gains for a sterling investor of buying in dollars in Year 1 and gaining a superior interest spread of 2% over the pound are wiped out by a completely offsetting depreciation of the dollar when the investor transfers those dollar gains back into sterling.
The conclusion is that according to the theory of UIP the strategy of investing in other countries to return a superior return in your home currency is futile. Further, the idea there is one global price of money (or real interest rate) means that the theory of UIP implies that the difference between interest rates between any two countries reflects merely differences in inflation, which are offset by subsequent movements in their currency pair. This is because the nominal interest rate in a country is approximately the sum of the real interest rate and the expected rate of inflation. In the final round, UIP simply embodies the idea that because the difference between interest rates across countries is accounted for entirely by differences in inflation, exchange rates are affected only by these differences because they must move to offset them.
It’s a neat theory but it is substantially flawed, as is the idea that real interest rates cannot vary between countries. Exchange rates are influenced by a range of factors, including economic and political uncertainty, trade flows, investment opportunities and speculative reasons. Additionally, exchange rates are influenced precisely because real interest rates can differ across territories. Countries can have high real interest rates because they offer attractive investment opportunities and not the other way round as global capital mobility theory implies. It is possible therefore for rising interest rates in one territory to correspond to its currency strengthening, either structurally or coincidentally. International money flows in keeping that country’s currency strong and yet real interest rates can remain high in regions with strong growth and good opportunities.
We see this in global markets today. Figure 1 shows how since the middle of 2016, US interest rates have divorced from UK rates, driven by the earlier rate hiking cycle of the Federal Reserve compared to the continued low rates supported by the Bank of England. With US inflation rising by less in this period, it can be said that real interest rates in the United States have risen in the last two years.
Figure 1: US and UK T-Bill yields since November 2015
Since mid-2016, sterling investor may have been attracted to US interest-bearing assets, but the currency worked against them. Between then and early 2018, the dollar weakened against sterling and something close to UIP held. However, since March 2018, this relationship has broken down as Figure 2 shows.
Figure 2: The dollar strengthens against the pound from March 2018 despite positive interest differentials.
The interest rate differential between US and UK assets continued to rise as the Federal Reserve pursued its rate-hiking policy and US real yields furthered their upward rise, yet the dollar also strengthened against the pound. Indeed, the dollar strengthened against most currencies (including the euro; see Figure 3) as global investors first responded to investment opportunities in the US at attractive interest rates and more lately on the back of rising uncertainty due to ongoing trade tensions.
Figure 3: The situation also exists for euro investors.
This means that a sterling or euro investor who took investments out of their own short-dated government bonds and placed them into US short-dated T-Bills would have made both a superior interest yield but also profited further when they transferred the gains back into their local currency. Those investments of course would have been fully exposed to exchange rate risk, but its outcome would not have been achievable had the currency risk been hedged in FX markets.
Recent experience shows we should throw out the theory of UIP*. It’s a neat, logical idea that just doesn’t hold over any reasonable time period in a complex real world. However, we should be clear; unhedged investment strategies carry significant risk and are attractive only if the investor has conviction on the direction of exchange rates.
If one believes the dollar will weaken in the next few months then an unhedged position in US fixed income is not prudent. If however one believes that the dollar will remain strong then such as position makes more sense. Indeed, it could be argued that there is a good case for this belief; with China and Europe showing signs of slowing down, there could well be a flight of capital to the US, keeping the dollar strong.
UIP therefore can break down over the short term because there is no such thing as a single global real interest rate, because global capital is not fully mobile and global investment opportunities are not fully substitutable. However, in the longer term something like UIP is more likely to hold as investment opportunities appear in different places. Today, it could be said that the US offers the attractive play. Tomorrow, it will be someplace else.
*Note: Covered Interest Parity (CIP), assuming there is no cross-currency basis, does hold by definition. Futures contracts and FX swaps that entities use to hedge currency risk are designed so that the gains from interest rate differentials are wiped out in exchange based on expectations of exchange rates at the end of the period of the contract. These expectations are governed by the basic interest parity relation described in the table. Market exchange rates can of course differ at the end of the contract meaning one party in the hedge could gain from the contract and the other could lose. If there is cross-currency basis, meaning that a premium is charged to borrow in another currency, CIP does not hold.
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