Forex Interest Rate Outlook

Our new DailyFX Interest Rate outlook report will be a perfect complement to our forex forecasts, as we have seen a strong historical relationship between currency rates and their attached interest rates. In fact, interest rates explain a good deal of the recent US dollar recovery; a clear shift in interest rate forecasts out of the US Federal Reserve has gone a long way to improve the dollar's stance against major forex counterparts.

Given that interest rates markets are the most liquidly traded in the world, we can easily find dependable interest rate instruments that show us exactly where market expect currency yields to go through the short and medium term. These rate forecasts in turn give us a much clearer fundamental bias for major currencies and clarify outlook for forex pairs. Read below to see our expectations for the US Dollar, Euro, British Pound, Japanese Yen, Canadian Dollar, Swiss Franc, Australian Dollar, and New Zealand Dollar.

• US Dollar Interest Rate Outlook: Bullish
• Euro Interest Rate Outlook: Bearish
• British Pound Interest Rate Outlook: Bearish
• Japanese Yen Interest Rate Outlook: Neutral
• Swiss Franc Interest Rate Outlook: Neutral
• Canadian Dollar Interest Rate Outlook: Bearish
• Australian Dollar Interest Rate Outlook: Bearish
• New Zealand Dollar Interest Rate Outlook: Bearish

US Dollar Interest Rate Bias: Bullish

US interest rates and rate expectations fell sharply from mid-2007 through early 2008, but the term structure on the US dollar yield curve clearly shows markets expect much more through the coming two years of trade. We measure medium term interest rate forecasts as the difference between short-term (3-month) interest rates and their longer-term counterparts (2 years).

The yield spread chart above clearly shows that rates and rate expectations fell sharply through the beginning of the year, but the spread between 2-year and 3-month rates has since turned positive and 2-year swap rates trade above 3.0 percent. This signals that traders believe interest rates will effectively only go up from current lows, and expectations for improvements in the US dollar's stance against major forex counterparts has easily boosted sentiment on the downtrodden greenback.

One caveat of course is the fact that the 3M-2Y yield spread has shrunken significantly from its 120 basis point highs seen in June. A relatively steady stream of bearish US economic data suggests that interest rates may not climb nearly as quickly as markets had initially expected. Such a development is inarguably bearish for US interest rates, but as forex traders we know that forex rates will vary according to the differences between currencies. That is to say, a similarly bearish outlook for global interest rates means that the US dollar may nonetheless continue to gain on a clear deterioration in forecasts for the euro, British Pound, and other key counterparts.

Euro Interest Rate Bias: Bearish

European interest rate forecasts have clearly weighed on the Euro/US dollar exchange rate, as expectations for European Central Bank interest rates cuts leave the euro at a disadvantage against its US counterpart. The difference between short-term Euro interest rates (3-month EURIBOR) and longer-term yields (2-year swap rates) now stands at 21 basis points in favor of the short end of the curve—indicating that traders expect rates to drop through the medium term. This stands in stark contrast to just three months earlier, when that same spread hit highs of over 50 basis points on market forecasts that the European central Bank would continue raising its short-term interest rate target.

Given bearish forecasts for euro yields and comparatively bullish expectations out of the US economy, our medium-term fundamental bias remains bearish for the EUR/USD forex pair.

British Pound Interest Rate Bias: Bearish

British Pound interest rate forecasts have undoubtedly played a part in the GBPUSD's sharp tumbles, and bearish interest rate developments will likely keep medium to long-term downtrends intact for the British currency. According to liquidly traded market interest rate instruments, traders previously predicted that the Pound's short term rates would gain by at least 50 basis points through the medium term. Yet the term structure of the British Pound yield curve now clearly shows that short-term yields (3-month LIBOR) are significantly above their longer-term counterparts (2-Year Swap Rates).

Clearly bearish and worsening forecasts for UK interest rates leave the British Pound at a clear disadvantage against the US dollar; markets expect that US yields will actually gain considerably through the medium term.

Japanese Yen Interest Rate Bias: Neutral

Japanese Yen interest rate forecasts have arguably played little role in the valuation of the US Dollar/Japanese Yen forex pair, and instead we see that global risk appetite and the US dollar dominate price movements in the low-yielding Yen. Given the lowest short-term interest rate among industrialized nations of 0.50 percent, traders will often sell the JPY against higher-yielding counterparts to collect the difference in rates. That said, it would likely take a truly material shift in Japanese rate forecasts to have a noteworthy impact on large interest rate spreads against currencies like the Australian and New Zealand dollars.

Markets currently predict that Japanese interest rates will remain relatively unchanged in the coming two years of trading, and as such, there is little interest rate bias for the Japanese Yen itself.

Swiss Franc Interest Rate Bias: Neutral

The Swiss Franc is one of the very few currencies in which markets believe that interest rates will rise through the medium term. Indeed, we see that the difference between 3-month CHF yields and 2-year rates stands at 7 basis points in favor of the longer-dated interest rates. This tells us that interest rate traders believe short-term interest rates will largely remain unchanged through the medium term, with a marginal probability of a Swiss National Bank rate hike in the longer-term. This gives us a fairly neutral interest rate bias for the Swiss Franc, but we note that such an assessment is favorable compared to an explicitly bearish bias for currencies such as the British Pound, Australian Dollar, and New Zealand dollar.

Canadian Dollar Interest Rate Bias: Bearish

Canadian Dollar interest rate expectations technically improved through recent months, as surprisingly stable Bank of Canada interest rates boosted the Loonie's stance against the lower-yielding US dollar. Indeed, short-term Canadian Dollar interest rates shot higher when the BoC surprised traders by leaving rates unchanged at recent meetings. Yet interest rate traders feel that the BoC simply put off the inevitable, and longer-term yields have remained comparatively unchanged. As such, we view a sharply negative 2-year yield – 3-month LIBOR interest rate spread a bearish development for the Canadian dollar on a longer-term basis—leaving our interest rate bias to the downside for the CAD.

Australian Dollar Interest Rate Bias: Bearish

The Australian dollar currently enjoys the second-highest short-term interest rates of the G10 currency universe, but sharply negative rate expectations clearly diminish the attractiveness of Aussie yields. Deterioration in fundamental outlook for the Australian economy has clearly played a part in outlook for domestic interest rates, as forecasts for a broad slowdown in global economic growth hurts highly export-dependent Australian growth. Given such dynamics, interest rate prospects are almost inarguably bearish for the Australian dollar through the foreseeable future.

New Zealand Dollar Interest Rate Bias: Bearish

The New Zealand Dollar boasts the highest short-term yields of any G10 currency, but we see that sharply negative interest rate expectations leave rate bias decidedly negative for the previously high-flying NZDUSD. 2-Year NZD yields currently trade a full 100 basis points below their 3-month equivalent, as interest rate traders price in aggressive interest rate cuts from the Reserve Bank of New Zealand. Given that the NZD previously rallied on its sizeable yield advantage versus major forex counterparts, such developments leave a decidedly bearish bias for the currency itself. Indeed, if it sees its sizeable carry advantage fade, the New Zealand dollar may embark on a sizeable medium-to-long-term downtrend against lower-yielding forex counterparts.

DailyFX

Disclaimer

Investment in the currency exchange is highly speculative and should only be done with risk capital. Prices rise and fall and past performance is no assurance of future performance. This website is an information site only. Accordingly we make no warranties or guarantees in respect of the content. The publications herein do not take into account the investment objectives, financial situation or particular needs of any particular person. Investors should obtain individual financial advice based on their own particular circumstances before making an investment decision on the basis of the recommendations in this website. While we try to ensure that all of the information provided on this website is kept up-to-date and accurate we accept no responsibility for any use made of the information provided. All intellectual property rights are the property of Daily FX. Daily FX and its affiliates, will not be held responsible for the reliability or accuracy of the information available on this site. The content herein is provided in good faith and believed to be accurate, however, there are no explicit or implicit warranties of accuracy or timeliness made by Daily FX or its affiliates. The reader agrees not to hold Daily FX or any of its affiliates liable for decisions that are based on information from this website. Daily FX highly recommends that before making a decision, the reader collects several opinions related to the decision and verifies facts from at least several independent sources.