If unconventional tools are used as a substitute for rate hikes, how does FX respond?

Author: Eamonn Sheridan | Category: Education

I spotted this during the week and thought I'd post it up for the weekend

Its via HSBC, titled 'FX and yield curve', and the broad 'rules of thumb' are summarised below:

The market is increasingly fixated on the prospect of unconventional tightening. In the US the focus is on a reduction of the Fed balance sheet and in Europe there is an expectation of a tapered rate of bond buying by the ECB.
In a normal tightening cycle, hikes in policy rates would lead to an increase in short-term interest rates and this has typically led to a stronger currency. The FX market understands this process well. However, if unconventional tools are used as a substitute for rate hikes, how do we deal with this in the FX market?

Unconventional policy measures may change the shape of the yield curve as much as they change the level of rates. So to answer this question we need to measure how changes in both the level and shape of the curve influence exchange rates.

Rules of thumb
We have modelled the relationship between changes in swap rates and FX returns. We note the following rules of thumb:
  • Not surprisingly, higher rates are associated with a stronger currency.
  • Once we have accounted for the change in the overall level of rates, a steepening curve is associated with a weaker currency.
  • When both the level and the slope of the curve change, the change in the overall level of rates is the most important variable.
These rules of thumb can help you to translate your views about interest rates into the FX space.

Model behaviour
In addition to the broad rules of thumb above, two other notable results will be helpful to those of you building formal models:
  • It is not just the interest rate differential which matters. In the FX market it is common simply to compare the FX return to changes in an interest rate differential. However, we find that this approach can miss important information and suggest that it is better to consider rates from both currencies as separate variables, rather than simply the differential.
  • The model parameters change over time. The sensitivity of FX to rates changes over time. This means that model parameters must be frequently updated to prevent them becoming stale.
Some food for weekend thought there