A recent FED meeting moved up interest rates. This has led to a series of effects which, while still ongoing, have resulted in a notable decline in prices for many commodities. This price decline will hamper employment in commodity-producing industries.
The relationship between interest rates and commodity prices relies on the relationship both have with foreign trade, as I’ll explain in two posts. In this, the first of those two posts, I will explain the effect the FED’s actions have had on currency exchange rates.
In the second post, I will talk about the decline in commodity prices which are observable for precious metals, natural gas, heating oil, aluminium, lead, nickel, pork, soybeans and soybean oil.
Theory:
Increases in real interest rates cause a currency to go up in value in foreign exchange markets. To understand why, one needs to first understand two forms of arbitrage (or near arbitrage) in foreign exchange markets. They are: 1) exports/imports and 2) interest differential arbitrage.
#1: Exports/Imports Arbitrage
Exports and imports are a form of arbitrage. Exporting a good from one country to another is taking advantage of a pricing opportunity.
For example, imagine 1 Canadian dollar is worth 1 American dollar and the price of oil is 1.25 US dollars per gallon in America but 1 Canadian dollar per gallon in Canada. Ignoring a bunch of complicated stuff like tariffs and transport costs we notice essentially how to make a profit through export/import. In exchange-adjusted terms, one can exploit a pricing inefficiency by buying a Canadian dollar with an American dollar, using the Canadian dollar to buy a gallon of oil and selling the gallon for 1.25 American dollars.
When enough market participants take advantage of export/import arbitrage opportunities, they will cause the markets to reprice, which reduces the profitability of the arbitrage.
To understand the pricing effects of the export/import arbitrage let's return to the US/Canada/oil example. Imagine there are firms that are exporting oil from Canada to the US. They can do this because the value of Canadian oil in Canadian dollars times the value of Canadian dollars in American dollars is less than the value of American oil in American dollars. Those firms will be increasing the Canadian price of oil because they are buying oil in Canada, increasing demand. They will be decreasing the American price of oil because they are selling oil in America, decreasing demand (the Americans who get imported oil won’t buy American-made oil). They will also be increasing the value of Canadian dollars in American dollars. This is because they are selling oil to Americans to get American dollars to turn into Canadian dollars to buy oil with. When they turn American dollars into Canadian dollars they are either increasing the demand for Canadian dollars in terms of American dollars; or they are increasing the supply of American dollars in terms of Canadian dollars. In either case, the price of the US dollar declines against the Canadian dollar (or vice versa). This means that the cost of buying oil (price of oil in Canada times the price of the Canadian dollar in US dollars) goes up; meanwhile the price of selling oil (the price of oil in America) goes down. So the arbitrage reduces the pricing differences.
Overall what the implications of the arbitrage means is that if 1 US dollar can be traded for 100 Mexican pesos; then 1 dollar can buy roughly the same in America as 100 pesos can buy in Mexico. When the exchange rate is exactly “fair” in the sense that one can exchange one currency for another when crossing a border and have exactly the same purchasing power, we can say the exchange rate is at “Purchasing Power Parity” (PPP). Exchange rates often hover around their PPP levels but are not necessarily equal to them. Factors like tariffs, transportation cost and market inefficiencies in the export/import arbitrage mean that currencies exchanges are not necessarily “fair.”
#2: Interest Differential
The PPP exchange rate is not the only predictor of exchange rates. Another significant predictor is “real interest differentials.” Real interest rates are interest rates minus the expected inflation rate, or the contractual rate of return on inflation-adjusted lending contracts. Real interest differentials are one country's real interest rates minus another country's real interest rates. Countries with higher real interest rates will have higher exchange values relative to the PPP (they will be unfairly highly valued).
The reasons for this are essentially another arbitrage opportunity. Because PPP is a significant predictor of exchange rates, countries which offer a high inflation-adjusted rate of return are an attractive place to put money. Oftentimes this investment strategy plays out through the currency futures markets. However, the mechanisms behind that are too boring and complicated to go into.
But essentially because PPP is a strong long-term predictor of exchange rates, real interest differentials become a strong short-term determinant of exchange rates.
Recent Data:
The FED meeting’s conclusion on June 16th significantly increased real (“inflation-adjusted”) interest rates on a 5-year basis, as the chart below shows. Similar significant increases occurred over a 7 and 10 year duration, although there was a less pronounced effect on 20 to 30-year timeframes.
At the time of the increases in the real interest rates in dollar markets, foreign money came flooding in, which pushed the value of the dollar up.
From our perspective, the value of all currencies everywhere else in the world went down.
The following charts are based on data from the investment website Marketwatch. They plot the US dollar value of the currency of America’s top 5 trading partners over the past year. With the exception of the Japanese Yen, the evidence of weaker foreign currencies stemming from the meeting is obvious.
