Interest Rate Differentials Leading Indicator Coincident Indicator or Lagging Indicator

Since most currency traders consider present and future interest rate differentials when making investment decisions, there should theoretically be some correlation between yield differences and currency pair prices. However, do currency pair prices predict rate decisions, or do rate decisions affect currency pair prices? Leading indicators are economic indicators that predict future events; coincident indicators are economic indicators that vary with economic events; lagging indicators are economic indicators that follow an economic event. For instance, if interest rate differentials predict future currency pair prices, interest rate differentials are said to be leading indicators of currency pair prices. Whether interest rate differentials are a leading, coincident, or lagging indicator of currency pair prices depends on how much traders care about future rates versus current rates. Assuming efficient markets, if currency traders care only about current interest rates and not about future rates, one would ex pect a coincident relationship. If currency traders consider both current and future rates, one would expect interest rate differentials to be a leading indicator of future currency prices.

The rule of thumb is that when the yield spread increases in favor of a certain currency that currency will generally appreciate against other currencies. For example, if the current Australian 10-year government bond yield is 5.50 percent and the current U.S. 10-year government bond yield is 2.00 percent, then the yield spread would be 350 basis points in favor of Australia. If Australia raised its interest rates by 25 basis points and the 10-year government bond yield appreciated to 5.75 percent, then the new yield spread would be 375 basis points in favor of Australia. Based on historical evidence, the Australian dollar is also expected to appreciate against the U.S. dollar in this scenario.

Based on a study of three years of empirical data starting from January 2002 and ending January 2005, we find that interest rate differentials tend to be a leading indicator of currency pairs. Figures 9.15, 9.16, and 9.17 are graphical representations of this finding.

These figures show three examples of currency pairs where bond spreads have the clearest leading-edge correlation. As one would expect from the fact that traders trade on a variety of information and not just interest rates, the correlation, though good, is not perfect. In general, interest rate differential analysis seems to work better over a longer period of time. However, shifts in sentiment for the outlook for the path of

Graph Audusd Interest Rate Differentials
figure 9.15 AUD/USD and Bond Spread

GBP/USD versus Interest Rate Differential

□ate figure 9.16 GBP/USD and Bond Spread

□ate figure 9.16 GBP/USD and Bond Spread interest rates over the shorter term can still be a leading indicator for currency prices.

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