Money is fundamental, interest rates are secondary

Let’s try one more time, with the dollar/yen forward exchange rate.  I’d like to make the following assumptions.  It doesn’t matter whether you think these assumptions describe the real world; I’d simply like you to consider them as a hypothetical.  When we’re all done, we’ll think about what it means.

1.  Let’s assume the BOJ is determined to adopt a very tight money policy, over the next 30 years.  This policy will be so tight that the yen will end up valued at 50 to the dollar, more than double its current value.

2.  This very tight money policy causes very low inflation and very low NGDP growth in Japan.

So far interest rates don’t enter the picture, indeed interest rates need not even exist—imagine a world with no debt. I’m trying to make the appreciation of the yen into the fundamental shock, from which everything else flows.

3.  Now let’s add interest rates.  Because of the ultra-low expected inflation, and the ultra-low expected NGDP growth, nominal interest rates in Japan are more than 200 basis points below nominal interest rates in the US.  These low rates are caused by a tight money policy that leads to yen appreciation.

I’m still assuming the tight yen policy that leads to yen appreciation is fundamental, and everything else is an effect of that policy.

4.  Now let’s assume that the US and Japanese debt markets are very deep and liquid, and the 30-year forward yen contract is very lightly traded and not very liquid at all.  Let’s also assume that the forward premium on the yen is linked to the interest rate differential according to the covered interest parity theorem, although the theorem doesn’t work perfectly due to various market imperfections caused by regulations.  It’s roughly true.

I’m still assuming the tight yen policy that leads to yen appreciation is fundamental, and everything else is an effect of that policy.

Now let’s take stock of where were are.  Thus far, I have NOT claimed to describe the real world.  I’ve described a scenario where, by assumption, the huge forward premium on the yen drives the interest rate differential.  Quite possibly, this imaginary scenario has nothing to do with the real world.

But here’s the problem.  Not one commenter has given me a single fact that would lead me to conclude that this imaginary scenario does not in fact describe the real world.  Note, for instance, that I assumed that the two bond markets are highly liquid and traders focus on the interest rate spread.  I assumed the forward yen is lightly traded, and hence considered peripheral in the world of finance.  But I’ve also constructed an example where, by assumption, that difference in liquidity between the two markets has no bearing on causality.

So what would count as evidence against my imaginary scenario?  Perhaps you could convince me that while the 30-year forward yen is 50, traders actually expect the yen to be trading at 105 in the year 2048.  And investors continue to buy low yield JGBs in any case, because of market segmentation, or some other reason.  So the differences in interest rates are unrelated to differences in inflation, etc. If you offered that sort of explanation, and backed it up with evidence, I would be persuaded.  But I’m not seeing people do that.  Until then, I’m going to assume the causality goes from an appreciating yen to a situation where Japanese interest rates are lower than American interest rates.

PS.  The “carry trade” may partly explain why people disagree with me, but carry trades suffer from the “peso problem”, so I’m not convinced the carry trade will “work” going forward.  If Japanese inflation stays well below US inflation (as I expect), then the carry trade will break down at some point.

PPS.  Financial variables may or may not be linked to macro events.  The 1929 stock market crash seems to have been linked to fears of depression, while the 1987 stock market crash seems to have been sort of random.  You can view my claim here as being that the 1929 case is more typical.  Asset prices move based on shifting expectations regarding economic fundamentals.  Even if a forward exchange rate market did not exist, I’d claim that expectations of the future spot rate drive the interest rate differential.



28 Responses to “Money is fundamental, interest rates are secondary”

  1. Gravatar of H_WASSHOI (Maekawa Miku-nyan lover) H_WASSHOI (Maekawa Miku-nyan lover)
    8. March 2018 at 12:46

    The Market expect that new economic union will be made?
    Maybe China or the other big country will buy YEN at generous price when some sort of annexation has made in the future.(?)

    When low global natural interest rate is new normal,maybe long-run economic insufficient cost of BOJ will pay the annexation cost from the other country.Seriously.

    {(BASE+private national debt)*(105/50)/(0.5 to 1% of RGDP)}/(discount rate)

  2. Gravatar of H_WASSHOI H_WASSHOI
    8. March 2018 at 13:41

    I favor the scenario some great country will buy yen at double price (maybe as some sort of unification policy) beyond B/C.

  3. Gravatar of Brian McCarthy Brian McCarthy
    8. March 2018 at 14:58

    I’ll make the case….

    I believe there is a fair bit of empirical evidence that current spot rates are a better predictor of future spot rates than are current forward rates. So a naive “long carry” strategy does generate positive returns over time. The reason this “free money” isn’t arbitraged away, I would imagine, is that the strategy doesn’t have a good sharpe ratio. ie low returns relative to the volatility. In market slang it’s “picking up pennies in front of the steam roller,” involving a significant risk of ruin if done “in size.”

    So the market really does “expect” the yen to be at 106 in 30 years, which is where it is today.

    Two reasons I’d toss out as to why people buy JGBs at 200 under Treasuries. Some segment of the market has Yen-denominated liabilities to match, so they have to. More important is the arb linkage between short and long interest rates. With the term premium tending to be low with a low rate structure, long-term rates are going to trade pretty close to the path of expected short rates.

    And with Japan seemingly unable (or unwilling) to effect a sufficiently expansionary monetary policy the market is expecting a shallow / flat path of short rates. Hence, long rates are very low.

    As a market practitioner in FX and international fixed income for 30 years, I’m pretty confident the causality runs from monetary policy effects and expectations to long-term interest rates. The long-dated forward FX rate just falls out of the covered interest parity equation.

  4. Gravatar of ssumner ssumner
    8. March 2018 at 18:08

    Brian, Very good comment. And yet I don’t agree with your conclusion. I believe the market rationally expects the yen to appreciate over time, because they rationally expect Japanese inflation to remain about 1% to 2% below US inflation. (I recall when the yen was at 350)

    The spot rate may be a good forecaster of future spot rates in normal countries, but it’s not the case in places like Brazil, Venezuela, Switzerland or Japan. In the extreme cases, it’s pretty clear where the currency is headed in the very long run.

    If people really did expect the yen to be 106 in 30 years, why wouldn’t US corporations issue bonds in yen? I get that there is some exchange rate risk, but the interest rate is so much lower that the risk only shows up in about 30 years, when the principal has to be repaid. Until then you pay . . .what, 2% instead of 4%? In dollar terms you pay less interest unless the yen falls to 50. In 30 years you take a hit (maybe, not if you are right), but that’s a long way out.

  5. Gravatar of Lorenzo from Oz Lorenzo from Oz
    8. March 2018 at 18:37

    The view from Australia is: of course Scott’s story is right, otherwise our macro history makes no sense. Our macro history only makes sense if what the RBA does with interest rates has different implications than what the Fed does with interest rates, because the policy regime is different.

  6. Gravatar of BC BC
    8. March 2018 at 20:25

    One explanation for the empirical historical success of the carry trade is that low yielding currencies tend to be safe havens, high yielding currencies tend to carry systemic risk, and the interest rate differential contains a risk premium for bearing that risk. I’m not sure whether that really applies for the JPY-USD though. I think it applies more for carry trades that are long emerging mkt currencies and short USD, JPY, or CHF. For the risk premium story to apply here, one would have to expect the JPY to rise sharply against even the USD in some types of crises. I have heard some people use rising JPY (and JPY volatility) as a warning sign for crises, but I don’t know how reliable that signal is.

    You may be correct that in this case most of the interest rate differential is due to differences in inflation and NGDP expectations. There may be some small fraction that is a risk premium.

    On the question of why US corporations don’t issue bonds in yen, which I think is asking why they don’t do the carry trade, maybe they have to mark those bonds to market?? If the yen were to appreciate suddenly, wouldn’t they have to recognize somewhere that their liabilities had increased? It seems like that should affect their credit rating, equity value, etc. Especially if the appreciation were to happen during a liquidity or financial crisis, then that would be the type of systemic risk that the interest rate differential was supposed to compensate for.

  7. Gravatar of BC BC
    8. March 2018 at 21:42

    Scott, just checking my understanding. Are you asking the following question, which can be stated either in terms of interest rates *or* forward exchange rates:

    (a) How much of the interest rate differential is due to monetary policy (expected inflation or NGDP) and how much is due to other factors such as risk, market segmentation, etc.

    *or equivalently*

    (b) To what extent, if at all, is the 30-yr forward exchange rate different from the expected exchange rate in 30 yrs due to factors other than monetary policy?

    So, it’s not really whether forward exchange rates drive interest rates or vice versa? That seems like asking whether the price of a dozen eggs determines the single-egg price or vice versa. You’re interested in the factors determining egg prices, whether priced by the dozen or individually, right?

  8. Gravatar of BC BC
    8. March 2018 at 21:57

    One more question, can (relative) monetary policy be expressed in three equivalent ways: (1) NGDP expectations, (2) (long-term) interest rate differentials, or (3) expected future exchange rates? Japanese monetary policy is tighter than US monetary policy if and only if (1) Japanese expected NGDP growth is lower, (2) Japanese interest rates are lower, or (3) the Yen is expected to appreciate relative to the USD?

  9. Gravatar of Doug M Doug M
    8. March 2018 at 23:56

    You have it backwards!

    An overly tight monetary policy will ultimately result in a weaker Yen. Even if, in the short term it may lead to some appreciation.

    It is similar to how tight monetary policy will cause a rise in interest rates in the short term, a persistent tight monetary policy will ultimately result in a lower interest rate.

    A tight monetary policy will result in a weaker currency.

  10. Gravatar of Julius Probst Julius Probst
    9. March 2018 at 02:12

    @ Doug, that’s wrong. I’m definitely siding with Scott here. You have it backwards. Consider tow countries, the U.S. with 2% inflation in the long-run and Japan with 0% inflation in the long-run, so a 2% inflation differential.
    What will happen to their respective currencies in the long-run?
    Well, the Japanese YEN must appreciate by about 2% against the dollar each year given the inflation differential in order to fulfil the Purchasing Power Parity condition, otherwise there will also be arbitrage opportunities in international good markets, which can’t happen. Traded goods must eventually have the same price internationally.
    The BOJ is making some effort to reach the 2% inflation target but they are falling short. Given recent history, one would expect the inflation differential between the U.S. and Japan to persist, meaning that the Yen will continue to appreciate in the long-run (just like it did over the last 4 decades going from 350 in the 1970s to now 100 !!!).
    So yes, an Yen dollar exchange rate of about 50 in 30 years is much more plausible than the current spot exchange rate.

    Anyone willing to take a bet?
    We can settle it in 30 years 😀 😀 😀

  11. Gravatar of Julius Probst Julius Probst
    9. March 2018 at 02:36

    The more interesting question is why the BOJ accepted a 0% inflation rate regime to persist for so many years. Only with Abenomics did they start to make a more credible promise to reach a higher inflation rate and it did work somewhat but they are still not doing whatever it takes.
    But financial markets still expect the inflation differential to persist, meaning continuous Yen appreciation.
    I’m starting to think that pegging the 10 year yield at zero was a mistake. It was a way to achieve low interest rates without having to buy much more Japanese bonds since they were worried that they were creating a shortage.
    What they really need to do is to stop the Yen from appreciating in the long-run.
    I don’t know where the equilibrium value of the exchange rate is, it’s hard to determine. Let’s say the Yen is somewhat overvalued. Depreciate it by 10% right now and then peg it to the dollar, then Japan will have the same inflation rate as the U.S.
    Of course, this course of action is maybe politically not feasible.

  12. Gravatar of Michael Rulle Michael Rulle
    9. March 2018 at 04:42

    It is just very hard to accept that arbitrage free pricing does not come as a package. If it is the objective of Japan, for example, to have a tight monetary low inflation policy it therefore must have a low nominal interest rate, relative to what it would have had, if it also wants its currency to appreciate. I am sure I could right that sentence in reverse (i.e., if it wants to have a low inflation tight money policy it must have an appreciating yen as its goal, which will lead to lower relative interest rates). But these two ways of stating the issue seem to mean the same to me. So if I am not getting your point, I probably never will.

  13. Gravatar of Mike Rulle Mike Rulle
    9. March 2018 at 04:54

    Maybe you are saying that monetary policy is driven by the central banks currency value objective. But that does not seem to be what you mean. You are always the mystery man!

  14. Gravatar of Sales Sales
    9. March 2018 at 05:41

    Hard to argue with any of this post, money is fundamental, its current value in relation to its expected future value is what gives us interest rates, so I suppose interest rates might be described as secondary. To be picky, a 30y price of $jpy at 50 in isolation tells us only about interest differentials rather than the individual monetary stances of the central banks . In a hierarchy of fundamentalism I would suggest that JGB andTreasury yields/30y interest rates rank above the forward FX rate. If your broader point is that current market pricing suggests that the BOJ is expected to fail to create much by way of positive inflation then consider the point well made.

  15. Gravatar of ssumner ssumner
    9. March 2018 at 08:35

    Lorenzo, Can you be a bit more specific? Are you saying they use interest rates in a different way–say to target exchange rates?

    Everyone, Lots of good comments, I’ll address this in another post.

  16. Gravatar of Carl Carl
    9. March 2018 at 09:18

    Are you simply saying that the necessary conclusion of a higher future value of the yen than the dollar at time T is that the interest rate on the dollar must exceed the interest rate on the yen over T?

  17. Gravatar of Andreas Reinsch Andreas Reinsch
    9. March 2018 at 12:37

    Hi Scott,

    I think that’s a very interesting discussion and I would like to add a few thoughts:

    You wrote the following:
    “Perhaps you could convince me that while the 30-year forward yen is 50, traders actually expect the yen to be trading at 105 in the year 2048.”
    In order to assume that the 30-year forward is equal to the expectation value of the exchange rate in 2048 you need to assume that real rates are the same in both currencies. Are there any reasons why we need to assume this? I think there are two good reasons why the real rates can be different:

    (1) Different default risks, although looking at CDS for shorter periods, the difference in risk seems to be small.

    (2) Different skew in the return distribution. This is probably the most important factor: JPY is together with gold and maybe CHF the ultimate positive skew assets. Hence they will most likely appreciate in times of crises which makes them one of the few real hedges against catastrophes. This implies lower real yield. Btw., that’s also why carry trade worked and should continue to be profitable, although with large draw-downs when crisis hits.

    I think there is actually currently a good counterexample for equal real rates: The EUR/USD pair.
    It seems that the real risk-free rates in EUR and USD are currently not the same. Looking at inflation indexed 30yr bonds of the US and Germany, the real rate in USD is around 1.0%, while Germany is -0.4%. In order to equalize real rates, the Dollar would have to depreciate in REAL terms by 1.4% each year, so about -30% over 30 years (or the Euro needs to appreciate by 50%). Given that we are not far from purchase power parity between the two countries, I would think that the depreciation of that magnitude of USD is extremely unlikely. That would mean that Munich would become almost as expensive as NYC.
    You can probably find 50yr bonds or swaps and make that calculation even more extreme.

    In addition, this analysis underestimates the need for USD depreciation:
    (1) German inflation index bonds are indexed to Euroarea inflation, not German inflation. I would argue that German inflation is expected to be higher than Euroarea inflation over the coming years. So USD depreciation would need to be higher than 1.4%. This can already be seen in French bonds, which are indexed to French inflation and which show a higher breakeven than German bonds.
    (2) US bonds have protection against strong deflation (they can’t lose money in nominal terms). That makes them more valuable. If you would make them equal to German bonds and remove that feature their value would be lower and rates even higher.

    Hence, I don’t think that the assumption of equal real rates is a good one and so the 30-year forward yen is not equal to the expectation value of the exchange rate in 30 years. The expectation value is probably somewhere between the 30yr forward and the spot rate.

  18. Gravatar of ssumner ssumner
    9. March 2018 at 13:26

    Carl, No. I’m saying that higher US rates are an implication of a higher future expected value of the yen.

    Andreas, You said:

    “In order to assume that the 30-year forward is equal to the expectation value of the exchange rate in 2048 you need to assume that real rates are the same in both currencies.”

    “Maybe I’m missing something, but I don’t see why. Suppose you have two countries which both have zero inflation. One has 0% real and nominal interest rates and the other has 20% real and nominal interest rates.

    Doesn’t the interest parity condition imply that the country with zero interest rates is expected to see its currency appreciate by 20% over the next year? In other words, even if the difference in nominal interest rates is due to real interest rates differing, doesn’t interest parity still hold?

  19. Gravatar of Q Q
    9. March 2018 at 18:09

    What’s it like in the land of irrelevancy?

  20. Gravatar of HL HL
    9. March 2018 at 19:05

    I think what you are saying can be whittled down to “investors in different asset classes are ultimately trying to price the same thing, which is inflation (level and change)”. That is, rates, FX, and equity investors are, in aggregate, coming to a collective judgment on the long-term trajectory of inflation but simply expressing it differently. That way, everything kinda comes together. You don’t need an actual trade to occur in a particular segment of market pricing because all you need is logical consistency.

    You discussed in this blog on many occasions that people should not reason from interest rates. I think that extends to the BOJ yield curve target because it is unclear (when the commitment is made upfront) how the Bank achieves 0% yield over 10 years. Either you get constant deflation that prevents you from achieving higher yield, some sort of historic depreciation of the yen accompanying genuine inflation regime change, or something in-between. As you said, if 0% target had been a genuine game changer, we would’ve seen exceptional steepening of the JGB curve between 10 year and 30 year. We haven’t really seen this. As you suggested, the rough answer is that markets still don’t believe the relative inflation will be materially higher in Japan vs. other countries.

    What’s specifically behind that assessment? I have my guesses, but it is difficult to answer. It is clear that there is significant political discomfort with NIRP. The BOJ already owns roughly 45% of outstanding JGBs (which means that they probably have 40% or so before hitting the constraints caused by life insurers’ liability matching needs) and 56% of ETFs. Muni debt is only 7% of JGB. Political hurdles for individual stock and loan purchases are substantial and nearly prohibitive for foreign debt purchases (domestic legal prohibition on doing it for FX targeting and also G20 consensus). Then there is the obvious question of inter-generational tension on inflation simply because Japan has been dragging its foot for too long and roughly 1/3 of population draw pension income. I think there are good reasons why markets remain skeptical on the BOJ resolve. They can still change this perception, of course, but…we shall see.

  21. Gravatar of Benjamin Cole Benjamin Cole
    9. March 2018 at 19:52

    Japan mentioned here:

    I had forgotten that Ben Bernanke hinted “helicopter drops” would be advisable for Japan, back in 2003.

  22. Gravatar of Julius Probst Julius Probst
    10. March 2018 at 05:40

    Scott, I was inspired by your blog post and wrote a short one of my own.
    Here is also some data on inflation rates (and inflation differentials) for the US and Japan: CPI increases are about 1.7% higher in the US than Japan from 1970 to 2013. We thus expect the Yen to appreciate by a little more than 200% (1.017^43) over the same time period based on PPP, which is exactly what happened

  23. Gravatar of salmo trutta salmo trutta
    10. March 2018 at 05:49

    “while the 1987 stock market crash seems to have been sort of random”

    Interest is the price of loanable funds / available credit. The price of depreciating money is the reciprocal of the price level.

    See: Dr. Daniel L. Thornton, Vice President and Economic Adviser: Research Division, Federal Reserve Bank of St. Louis, Working Paper Series, “Monetary Policy: Why Money Matters and Interest Rates Don’t”

    1987 wasn’t “random:

    1987 was the litmus test for Central Bank stupidity (no black swan). Even Robert Prechter’s Elliott Wave International got it exactly right.

    Monetary flows (volume X’s velocity), fell from 16 in AUG, to 4 in NOV (See G.6 release – debit and demand deposit turnover). [ Δ, not Δ Δ ] Note, money flows, bank debits (money actually exchanging counter-parties), turned negative during the S&L crisis.

    Conterminously (3 months prior to the crash), the rate-of-change in RRs (the proxy for R-gDp), was surgically sharp, decelerating faster than in any prior period since the series was first published in January 1918. The proxy declined from 11 in JUL to (-)4 in OCT. [ Δ, not Δ Δ ]

    Accompanying this sharp deceleration in the RoC for M*Vt (proxy for all transactions in American Yale Professor Irving Fisher’s truistic: “equation of exchange”, the monetary authority mis-judged macro-economic strength (like the last half of 2008), and on Sept. 4 the FOMC raised (1) the discount rate, which was not yet a penalty rate, 1/2 percent to 6%, & (2) the policy FFR 1/2 percent to 7.25% (up from 5.875% in Jan).

    Black Monday began when the target FFR was increased to 6.5% on 9/4/1987. The effective FFR began to trade above the policy rate c. 9/22/1987 (constrained by reserve demand). The effective FFR spiked on Thursday (the very first day of the reserve maintenance period).

    On Sept. 30 the effective FFR spiked at 8.38%; fell to 7.30% by Oct. 7; then rose to back to 7.61% Oct 19 (Black Monday). Thus, the effective FFR spiked 36 basis points higher than the FOMC’s official target, it’s policy rate on “Black Monday”.

    The shortfall in the quantity of legal reserves supplied by the FRB-NY’s trading desk (which had already dropped at a rate not exceeded at any time since the Great Depression) bottomed with the bi-weekly period ending 10/21/87. This was the trigger. However, the Fed covers: The Nattering Naybob’s “Elephant Tracks”. So you can’t run a regression against the historical time series.

    At the same time, the 30 year conventional mortgage yielded 11.26%, up from 8.49% in Jan. 87, & Moody’s 30 year AAA corporate bonds yielded 11.06% on 10/19/87, up from 9.37% in Jan. 87.

    The preceding tight monetary policy (monetary policy blunder), i.e., the sharp reduction in legal reserves (mirroring the absolute decline in our means-of-payment money), had effectively forced all rates up along the yield curve in the short-run (when inflation and R-gDp were already markedly subsiding). I.e., interest is the price of loan funds, the price of money is the reciprocal of the price level.

    Note: interest rates may either rise or fall during the short-run, in response to the FOMC tightening policy, depending upon the “arrow of time”, and the monetary fulcrum (the thrust of inflation).

    On 10/19/87 the CBs had to scramble for reserves (too stringently supplied relative to demand) at the end of their maintenance period (bank squaring day), to support their loans-deposits (it is noteworthy that contemporaneous reserve requirements were then in effect exacerbating the shortfall & response time).

    A significant number of banks, with large reserve deficiencies, tried to settle their legal reserve maintenance contractual obligations at the last moment. But the FRB-NY’s “trading desk” failed to accommodate the liquidity needs in the money market – until it was already way too late (i.e., ignored their perversely coveted interest rate transmission mechanism).

    I.e., it was a major monetary policy blunder by the Maestro, Chairman Alan Greenspan. And economists don’t talk about what the ABA doesn’t want them to. See – Sent: Thu 11/16/06 9:55 AM “Spencer, this in an interesting idea. Since no one in the Fed tracks reserves (because the ABA and stupid economists want to eliminate them)…” and “Today, with bank reserves largely driven by bank payments (debits), your views on bank debits and legal reserves sound right!” – Dr. Richard G. Anderson

    Oh wait, wasn’t the crash blamed on programmed trading (reflecting academic censorship and fake news). It’s not: Don’t fight the Fed. It’s: Don’t fight the ABA.

  24. Gravatar of Salmo trutta Salmo trutta
    10. March 2018 at 05:52

    Scott Sumner:

    “Money demand slopes downward. Higher interest rates raise velocity. Period. End of story.”

    “Everyone knows that the real demand for money slopes downward, as a function of the nominal interest rates. It’s in all the textbooks.”

    [which is of course wrong, viz., Alfred Marshall’s “money paradox”]

  25. Gravatar of Matthew Waters Matthew Waters
    10. March 2018 at 16:28

    I don’t know how feasible an arbitrage trade over 30 years is. Any trade involving shorts or borrowed money has the impact of margin calls. Even if the trader has the liquidity resources to meet the margin calls, they impact their return.

    So if short positions are not feasible in a market, the efficient market price has to be determined by enough longs refraining to invest. IMO, convergence to the efficient price is slower with only longs in a market. If enough longs have irrational beliefs about a price to support it, there is nothing rational investors can do.

    These issues are heightened by the fact that most investors are agents for principals. The agents may have incentives for less than a year’s return, even if the principals have longer-term incentives. So trades which pay off longer than a year may not have sufficient liquidity to effect the efficient price.

    Now, I don’t know if this applies to Japan 30-year bonds. But I am very hesitant to attach “market says” type arguments with 30 year time frames.

  26. Gravatar of dtoh dtoh
    10. March 2018 at 23:09

    Consider the following assumptions.

    1. Both Japan and the US have 5% nominal growth.

    2. Japan has 5% real growth. The US has 0% real growth.

    3. Both Japan and the US have 5% nominal interest rates.

    The forward fx rate will be equal to the current fx rate because of interest rate parity.

    Under your theory, tighter monetary policy and lower inflation in Japan should imply a higher forward value for the yen, but clearly this will not be the case.

    Expectations for higher inflation (and/or tighter monetary) are built into the spot rate. The delta between the future rate and the spot rate is purely a function of the interest rate differential which may or may not correlate with differences in inflation or the stance of monetary policy.

  27. Gravatar of Andres Reinsch Andres Reinsch
    11. March 2018 at 06:35


    Thanks for your reply. Sorry, I think I wasn’t very clear in my original post. Here is my understanding of the issue:

    The difference in nominal interest rates predict the value of the forward FX contract. Up to a few minor adjustments that just follows from the no-arbitrage condition. So far so unspectacular.

    If the forward exchange rate is the best estimate of the future exchange rate depends on the difference between real interest rates of the two currencies as measured in the same currency.

    To go back to your example of two countries A and B with both having zero inflation and real and nominal rates of A=0% and B=20%. Due to arbitrage the forward rate of B/A country must be 20% lower than the current exchange rate, since that is defined by the no-arbitrage condition.

    However, the expectation value of the future exchange rate can be anything. It is only 20% lower than the current FX rate if the real interest rate as measured in the same currency is the same for both countries. Otherwise it would be different.

    You could as an example imagine that the future expectation value is equal to the current exchange rate. That would mean that measured in currency A, the real return after one year in currency A is 0% (by definition 0% interest, 0% inflation) and in currency B is 20% (20% interest plus no FX change, 0% inflation).
    My point above was that there can be many reasons for different real rates as measured in the same currency for different countries. One major difference is probably differences in return distribution. That’s why investors are happy to hold JPY or CHF with probably lower real rates than USD investments when measured in USD. For those currencies, the forward rate is probably different then the expectation value of the future’s exchange rate.

    As a conclusion, there is no surprise that the 30-year forward yen is around 50. But I’m much less certain that the expectation value is also at that level. I would expect it to be higher due to lower JPY real rates than USD real rates as measured in the same currency.

  28. Gravatar of ssumner ssumner
    12. March 2018 at 15:58

    Andreas, I agree that the expected future yen may not be at 50; my claim was that this is the most straightforward explanation.

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