The GBP/EUR FX rate should fall given that the European Central Bank has raised EUR interest rates. But as the price chart shows that wasn’t the first reaction. Which means that the first run of theory either doesn’t work entirely, or doesn’t work on very short term price reactions.
The standard foreign exchange price theory is that all is determined by relative real interest rates. But do note that’s real interest rates, not nominal. The argument is that if we’ve 100 (no, not 100 what, just 100) and we can put it in one currency where we get 5% and another where we can get 10% then the 10% currency will rise against the 5% one over time. Because money will move to gain that higher return. But again, note that’s real interest rates - after we’ve adjusted for inflation. It’s this which makes predictions of FX rates based upon nominal interest rates so difficult. For we’re aware that nominal interest rates will affect the inflation rate. But how much, at what point in the cycle, in which structure of an economy, well, it’s complex.
GBP/EUR FX rate from Google Finance
As we can see there for: “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.” Nominal euro interest rates have just risen. But does that mean that real interest rates have? For what is the effect of the interest rate rise on inflation going to be?
This is what allows GBP to rise against EUR even as the nominal interest rate differential changes the other way. Then, again as we can see, there’s reconsideration and the price moves the other way.
We then, for of course we do, get into another level of complexity about FX rates. What’s the Bank of England’s next interest rate move? The ECB is here indicating that they’re probably at the top of the cycle. The Federal Reserve is also indicating - but neither are confirming absolutely - the same idea. The BoE is a bit more wayward in its guidance so far.
So what’s really driving the price is the consideration of what everyone does next rather than what has just been done. FX trading is not an informationally simple endeavour.
