By GRAHAM FROST 13/01/2009
One of the visible benefits of diversification over 2008 was the appreciation of currencies versus sterling. Since the forward prices of currencies merely reflect the differential in interest rates between countries, how much of the actual movement in exchange rates was due to factors other than changes in interest rate expectations? The moves were considerable and an important driver of returns for sterling based investors. For example, against the dollar, euro, and yen the pound fell 27%, 24%, and over 40%!
In early December 2007, official interest rates in the UK, Eurozone, US, and Japan were 5.5%, 4.25%, 4.0%, and 0.5%. Consensus inflation expectations for 2008 were between 2% and 3% for the first three and 0.4% in Japan. By early December 2008, after a roller coaster ride on commodity prices and the impact of the credit crunch, official interest rates were 2%, 2.5%, 1%, and 0.3% respectively. Inflation expectations for 2009 were just over 2% for the first three and 0.8% in Japan.
In other words, there was nothing in the real rates of interest on offer over the period, had you known them in advance, that would have enabled you to guess the actual outcome in terms of exchange rate moves. Clearly, investors were driven by different considerations. These included a flight to safety, the reversal of the Yen carry trade, and geopolitics. The UK was the big loser as investor perceptions changed for the worst regarding the ability of a heavily indebted nation to grow in future.
Interest rates and inflation expectations globally are even lower as we enter 2009 and of little use in determining exchange rate moves. Investors are likely to remain safety conscious for the foreseeable future as the economic situation worsens but it seems likely that much of the currency moves have already occurred. In theory, investors should reward the strongest countries who do not persist in running trade deficits, who exhibit fiscal discipline, face a politically secure future, and can manage their way out of the credit crunch without long term damage to their economies. There is not much to choose from.