"In a Tight Spot Are We?"

There have been some pretty significant currency and interest rate movements in the past year. To be honest, it's slightly difficult keeping track of the combinations; higher currencies with stable interest rates, higher currencies with lower interest rates, stable currencies with falling interest rates etc. To try and rationalise things, we've used a simple set of rules to keep track of it all, in order to get a sense of whether things are tighter now than they were a year ago, looser or about the same.

However, it is easy to think of tightening as a change in interest rates compared to a year ago, but using the old rule of thumb that a 10% change in your currency is equivalent to a 1% change in interest rates, it is possible to get a sense of the additional tightening of policy coming out of the currency markets. Combining the two is a simple matter of addition. Notice here that we are not making a judgement on the absolute level of tightness, but instead, we are seeing where we are now, compared to a year ago.

Some interesting things start to show up when the calculation is done over time. It can be seen from the first illustration that despite the efforts of the U.S. Federal Reserve, the recent decline of the dollar has effectively loosened policy. This has happened to such a point that any further decline in the dollar may force the Fed to increase interest rates in order to maintain the tightening momentum.

Looking at the situation in the United Kingdom and Europe. In both instances, the rising interest rate environment and the rise of their trade weighted currencies have come together to produce policies that would imply a 1.5% tightening of policy compared to just one year ago. This is substantial, and may yet come back to bite the export-driven European markets.

Results for Japan are equally illuminating (see fourth illustration). The stable interest rate policy has combined with stability in a range currency policy to such an extent that, compared to a year ago, things are virtually unchanged year-on-year.  

If this combination of interest rate changes and currency changes over a year has any worth, then it throws up some intriguing possibilities. First of all, to loosen policy in the U.S. the Fed needs do nothing besides let the U.S. dollar decline in a way that frankly satisfies a number of agendas, not least of which would be to increase their export competitiveness. Secondly, the rise of the European currencies is combining with interest rate rises in a way that, going forwards, could be very unhealthy. Finally, if Japan truly wants to tighten economic policy there is no need to touch the politically sensitive issue of interest rates. Why not just allow the yen to appreciate to about ¥110 to the U.S. dollar and thereby create an effective tightening of policy? We believe that America, Europe and China would all applaud such a move.

In portfolio terms, it can be understood why we have been so keen to be underweight in both the U.S. dollar and Japanese yen, and overweight in the European currencies. However, that policy should come to an end during 2007. More to the point there is a growing case to increase the yen content of unhedged portfolios going forwards. We will lay out in subsequent papers why the timing of a unilateral appreciation of the yen is probably a fourth quarter event. However, for the time being, it seems right to warm up our audience to future material moves and, where we have been substantially underweight the yen, reduce that extreme position for the time being.