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How does public debt affect currencies?
By now, we all know that in the short run, interest rates and currency valuations are often correlated. In the long term, however, interest rate parity dictates that a country’s currency should move in the opposite direction as its domestic interest rates, in order to guarantee that investors in different countries receive comparable returns. This is consistent with financial economics, in that higher-yielding securities tend to elicit less demand, which means that the corresponding currencies sag due to insufficient capital inflows. Now, let’s apply this theory to the recent downgrade of Italy’s public debt. This downgrade will drive Italian interest rates higher as risk-averse investors flee Italy in search of safer investments. (Bond prices and interest rates move in opposite directions) The resulting capital outflows would cause the Italian currency (if it still existed) to depreciate. Fortunately for Italy, the capital outflows it suffers will be spread across the entire Euro-zone, and the net effect on the Euro will be negligible.
Read More: Euro shrugs off Italy downgrades
Euro shrugs off Italy downgrades
By Peter Garnham
Published: October 19 2006 11:48 | Last updated: October 19 2006 16:56
dollar
The euro advanced against the dollar on Thursday, despite rating agency downgrades for one of the single currency’s founding members.
Standard & Poor’s and Fitch both downgraded Italy’s sovereign debt, citing the increase the country’s public debt.
Analysts were quick to quash the idea that Italy might move to pull out of the eurozone, saying that while the timing of the announcements might have caught the market off guard, the downgrades in themselves were hardly a surprise.
Marc Chandler, currency strategist at Brown Brothers & Harriman in New York, argued there were two chances that Italy would exit the single currency: “Slim and none, and none just left town,” he said. “As rough as inside the eurozone might seem, outside for Italy would be worse. This is a non-starter.”
By mid-afternoon in New York, the euro stood 0.5 per cent higher against the dollar at $1.2595.
For its part, the dollar slipped back, easing 0.4 per cent against the yen to Y118.40 and 0.4 per cent against the pound to $1.8750, giving back some of its gains from the previous session.
Analysts said the relative lack of volatility in the dollar since its sharp climb last week reflected the fact that the adjustment in the market’s view of US interest rates was now priced in.
Hawkish rhetoric from the Federal Reserve and more upbeat US economic data has changed the market’s view on US interest rates over the last two weeks, moving from expecting the Federal Reserve to cut rates to a neutral stance.
However, there was still plenty of debate about whether the US economy was headed for a hard of soft landing.
Rob Carnell, analyst at ING Financial Markets, said the constant rhetoric from the Federal Reserve, talking up the ongoing risks from inflation, was losing credibility. “With inflation looking less of a risk, those economists calling for further US rate hikes are looking increasingly out of touch with reality,” he said. According to Mr Carnell, while lower gasoline prices were providing a temporary boost to US activity and confidence, in a month or so the confluence of weaker inflation and growth would start to make rate cuts look an imminent probability.
Chris Towner, consultant at risk manager HIFX, disagreed, pointing to recent US economic data and robust corporate earnings. Mr Towner said he expected the Federal Reserve to keep US interest rates on hold for the rest of the year, and even saw the potential for another rise in 2007.
Elsewhere, sterling eased 0.1 per cent against the euro to £0.6720 after data showed retail sales had fallen unexpectedly in September. With analysts expecting a rise in UK retail sales of 0.3 per cent, figures showing a drop of 0.4 per cent put pressure on the pound.
However, Howard Archer, economist at Global Insight, said the figures were unlikely to deter the Bank of England from raising interest rates in November since they also revealed the first rise in the retail sales deflator since January 2002. “This will add to the Bank of England’s suspicion that retailers are increasingly pushing through price increases to consumers,” he said.
The Swiss franc rose 0.7 per cent against the dollar to SFr1.2615 and climbed 0.2 per cent against the euro to SFr1.5890 after strong retail sales data and news that Switzerland’s monthly trade surplus hit a new record in September, rising to SFr1.83bn from SFr544m in August.
However, Gavin Friend, strategist at Commerzbank, said while the news was a slight positive for the Swiss franc, it was unlikely to take the recent pressure off the currency, which has suffered as low Swiss interest rates have seen it increasingly used to fund carry trades. “These figures won’t change the Swiss National Bank’s stance on interest rates,” he said.
Copyright The Financial Times Limited 2006
http://www.ft.com/cms/s/57e79288-5f55-11db-a011-0000779e2340.html
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