Dollar Strength Will Pose Unforeseen Risks

The Interest Rate Gap

The dollar's weakness, particularly with respect to the euro, has been a function of nominal interest rate differentials and of special factors. At any maturity worldwide, there can be only one real rate of interest; otherwise, arbitrage would occur. As nominal interest rates are this real rate plus expected rates of inflation, relative currency strength should be a function of differences in expected inflation between any two zones.

The Transatlantic Rate Gap And The Euro

Source: Bloomberg

This is a wonderful theory, but it tends to get knocked around quite a bit in the real world. Prior to the introduction of the euro five years ago this week, the dollar and deutsche mark traded quite closely to their interest rate parity values. Since the advent of the euro, the rate gap and the currency have followed very different paths. Six-month rates in the U.S. started to narrow relative to their European counterparts in the summer of 2000, but the euro continued to weaken and remained on the ropes even as the rate gap moved in favor of euro deposits.

Much of that weakness is thought to be due to various forms of national cash that had been hidden from the continent's tax collectors being sold surreptitiously for dollars prior to the introduction of euro cash at the start of 2002.

The nominal interest rate gap has not changed much since last June, but the euro continues to dance as if the band were still playing. The 16.4% run the currency has put on since the beginning of September can be justified if the market could see higher expected inflation in the U.S. than in Europe, but with nominal 10-year note yields virtually identical in the two zones, that is a difficult argument to make. One could propose the euro is responding to higher growth prospects in Europe than in the U.S., but that argument is inconsistent with virtually all reported macroeconomic data and forecasts.