Rising U.S. Rates Could could trigger a reversal of capital flows, potentially destabilizing currencies in places with higher rates

  • Federal Reserve officials this week signaled that the end is near in the difference between Australian and U.S. interest rates, which has been positive since 2001.
  • As the Fed raised short-term rates by a quarter percentage point on Wednesday, it projected two more such increases in 2017: If it carries through, the upper end of the target range for U.S. rates will be 1.5% by the year’s end—where Australia’s benchmark rate is now.
  • The closing U.S.-Australian rate gap is a standout example of a trend currently looming over foreign-exchange markets: the narrowing difference between U.S. and global interest rates. While the Fed is now in tightening mode, many central banks that have long had higher benchmark rates—such as those in Australia, India and Brazil—are on hold or cutting.
  • Currency players often seek to profit from interest-rate gaps, known as the “carry,” by investing in stocks, bonds and currencies in countries with higher rates. Now, rising U.S. rates could trigger a reversal of such capital flows, which could prove destabilizing for countries that had benefited from the search for yield during the years when U.S. rates have been ultralow.
  • Moves in the euro in 2014 show how changing interest-rate differentials can result in bad blood for currencies.
  • The European Central Bank pushed its key interest rate negative in June 2014, while the Fed’s target range for its benchmark rate stayed between 0% and 0.25%.
  • The gap between the two regions’ rates has since widened, as the U.S. has started tightening. The euro dropped 12% against the dollar in 2014, 10% in 2015 and 3.2% in 2016, according to Thomson Reuters data.
  • Some investors are sanguine about the impact of narrowing interest-rate gaps, arguing that other factors can influence currencies. A rebound in commodity prices and solid economic data in China, a major trading partner, have brightened Australia’s outlook, helping propel the Aussie to a gain of 6.5% this year against the U.S. dollar.
  • And even as the Fed pushes ahead with rate increases, the currencies of some countries could remain attractive as their interest rates remain much higher, investors and strategists say.
  • They recommend owning high-yield darlings like the Indonesian rupiah and Indian rupee, where benchmark rates are 4.75% and 6.25%, respectively, providing a substantial buffer against rising U.S. rates.
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