Commentary: Interest Rate Parity catches up with USD

Most commentators assume that the only thing currently keeping the USD afloat is high interest rates. While attractive rates have certainly encouraged an inflow of (risk-averse) foreign capital in the short term, they may ultimately be harming the currency in the long-term. In fact, the economic law of interest rate parity dictates that currencies and interest rates should move away from each other in the long term. Stated
differently, high interest rates should imply a less valuable currency. Since US rates are among the highest in the world, the USD should decline in the long term in order to compensate US investors in foreign securities for the lower risk-free returns they are implicitly accepting.

The reasoning is simple enough: since the advent of currency futures, traders have been able to speculate on future exchange rates. In order for futures to be priced fairly (such that arbitrage is impossible) the difference between a currency’s current value and its implied future value should perfectly equal the difference between domestic interest rate levels and international interest rate levels. In the case of the US, bets on the USD made during the recent period that US interest rates have exceeded European and British interest rates, must have been predicated on a declining USD in the future, which is now the present.

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