Forex traders pay close attention to monetary policy because interest rates play a pivotal role in the fluctuations of currency pairs.
The policy rate sets the tone for the bond rates. And the relative attractiveness of bonds is what drives investors to buy or sell given currencies. Generally, the higher the relative bond yields in a currency, then the stronger the currency will be.
That has been a very simplistic description of conventional wisdom. But in the post-pandemic world, that could be changing.
That said, trading strategies may need to be modified to suit the new reality. It could explain why some trading strategies aren't as effective. So, let's go over why this is happening, and whether we are looking at a new normal.
It's not just the interest rate
Most economies in the world spent a lot of money dealing with the effects of the pandemic, expanding the monetary base. But they didn't all do it in the same way, or in the same amount.
So, while inflation around the globe is generally rising in part due to fiscal policy, it's not the same in every country. And the means to deal with that aren't necessarily the same, either.
The classic way that central banks reduce liquidity is by raising interest rates, making borrowing money more expensive.
Money in the modern world is essentially created through debt issuance. Therefore, if debt is more expensive, then less people will take out loans, and there will be less circulation. That's the theory.
But central banks aren't always right. Case in point, the current inflation situation, where we are well into month 10 of "transitory" high inflation.
So, why the disconnect
During the pandemic, interest rates were low, so a lot of companies took advantage to issue debt.
Sure, there were many firms who went into the pandemic with high leverage and had to reduce their debt holdings (or simply went bankrupt). Nevertheless, the total amount of corporate debt increased substantially over the last couple of years.
Now, the companies that needed money have all stocked up on debt. And with interest rates rising, they are less inclined to borrow more. Meanwhile, central banks have been snapping up corporate debt, particularly in Europe, but not so much in the US.
In the US, the Federal government issued a lot of short-term debt as it faced down a debt ceiling towards the end of the pandemic. It now must roll over that debt as interest rates are rising.
It's supply and demand
On a basic level, prices are determined by supply and demand. With less corporate issuance, then corporations could demand better terms (that is, lower interest rates).
However, central banks are pushing to raise rates, meaning that better terms are not available. So, interest rates are rising, but not "organically".
In other words, bond yields aren't reflecting the market so much as they are reflecting a push by regulators. And that distortion can have some unexpected effects down the line, which is where forex comes in.
Central banks regulate interest rates by buying up bonds or selling bonds. Therefore, if central banks want higher rates, they have to withdraw capital from the bond market. That is, stack the table in favor of bond buyers. Those are the people with cash, who hunt around for the best bond yields where they can park their money.
Figuring out the market forces gap
It's natural for capital to flow toward higher interest rates, which means buying that currency and pushing it higher. That's normally how forex and bond yields are connected. But that assumes that interest rates will stay higher.
Right now, the consensus is that central banks are raising rates to deal with inflation. Once that's achieved, then rates would likely moderate. That said, near-term rates could go higher than longer-term rates (the infamous "curve inversion").
When the disconnect happens
Investors generally move their funds based on where interest rates are expected to be, not necessarily where they are. So even if rates are rising at the moment, the potential for a retracement in yields in the near term as central banks moderate their tightening and turn to a more neutral stance, could be the driving force between currencies.
Thus, it isn't surprising to see some headlines about how a particular currency didn't get stronger despite rising yields. The issue might be that investors don't think those higher yields are sustainable. Particularly as more analysts start hinting that a new recession is coming, and central banks will be forced to cut rates.
