The EUR/USD FX rate is up today, some 0.26% so far. This, at least so far, accords with standard theory about exchange rates. They should be driven by the difference in real interest rates in the two currency zones. Therefore if the European Central Bank has just raised euro interest rates by a quarter percent - it has - then the euro should climb against the dollar.
The news: “Inflation continues to decline but is still expected to remain too high for too long. The Governing Council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner. In order to reinforce progress towards its target, the Governing Council today decided to raise the three key ECB interest rates by 25 basis points.” Like all central banks the ECB only controls short term rates, the longer the term the more it is markets that dominate pricing.
So, we’ve that first taste of theory. Rising interest rates lead to a higher FX rate for that currency. This will, of course, all then change again if the Federal Reserve decides that they need to raise rates again.
However, it’s vital to understand that it’s the real interest rate that matters, not the nominal. So it’s also necessary to incorporate the effects of the inflation rate, if any. That then becomes a little more difficult. For that means trying to forecast what the change in the nominal interest rate is going to have on the inflation rate and therefore the real interest rate. We can indeed assume - as the ECB is doing - that the rise in interest rates will curb inflation. But by how much?
EUR/USD FX rate from Google Finance
There’s then the next level of speculation - is the ECB really at the top of the interest rate cycle? Are we likely to see yet another rise? Or will the next move be a hold, or even down? And when will that be? We also need to add all of that for the Fed as well - are they really at the top of the rising cycle?
All of this is of course about FX rates over time. What’s actually happening in the foreign exchange markets is people trading upon their ideas of what all those interlocking factors are going to be in the future. It’s opinions now about what will happen then. And as we can see from the price chart that’s something that changes by the minutes, let alone the hours.
