Central Banks Working Together

Six central banks from around the world—the Federal Reserve (Fed), the Bank of England (BOE), the European Central Bank (ECB), the Bank of Canada (BOC), the Swiss National Bank (SNB), the People's Bank of China (BOC) and the Swedish Central Bank (Riksbank)—all cut interest rates in unison in a coordinated effort to stem the downfall brought on by the current credit crisis. The question is...how will these coordinated cuts affect the forex market—especially the U.S. dollar (USD) (Video Below)

Narrowing Interest Rate Spreads will Benefit U.S. Dollar (USD)

The coordinated interest rate cut will eventually lead toward a stronger U.S. dollar (USD). You see, currency pairs are heavily influenced by the interest rates of each currency's respective economy. Typically, the currency representing the economy with the higher interest rate is stronger than the currency representing the economy with the lower interest rate.

Simply having a higher interest rate however, does not guarantee a currency will be increasing in value when compared to the other currency in the pair. The interest-rate spread is actually more important. You determine the interest-rate spread by subtracting the lower interest rate from the higher interest rate. For instance, the interest rate in the United States is currently 1.50 percent while the interest rate in the Eurozone is currently 3.75 percent. This means the interest rate spread for the EUR/USD is 2.25 percent (3.75 - 1.50 = 2.25).

Forex investors watch the interest-rate spread between the two currencies to see if it is widening, narrowing or staying put because it gives them the following clues:

- Widening interest-rate spreads are typically a sign that the currency with the higher interest rate will be gaining strength

- Narrowing interest-rate spreads are typically a sign that the currency with the lower interest rate will be gaining strength

- Flat interest-rate spreads offer little information

Widening interest-rate spreads typically benefit the currency with the higher interest rate because interest-rate spreads can only widen if one of two things, or both, happen:

1. The interest rate of the currency with the lower interest rate gets cut (which is bad for that currency)

2. The interest rate of the currency with the higher interest rate gets increased (which is good for that currency)

Narrowing interest-rate spreads typically benefit the currency with the lower interest rate because interest-rate spreads can only narrow if one of two things, or both, happen:

1. The interest rate of the currency with the lower interest rate gets increased (which is good for that currency)

2. The interest rate of the currency with the higher interest rate gets cut (which is bad for that currency)

OK, so why am I saying that the USD will be the ultimate benefactor of this coordinated rate cut? After all, the interest-rate spreads didn't narrow for the EUR/USD, the GBP/USD, the USD/CHF or the USD/CAD. They remained flat.

To find out, watch the video below:

P.S. One caveat to my argument that the USD will strengthen is with the USD/JPY. After all, the interest-rate spread between the USD and the JPY narrowed between these two currencies—which benefits the JPY, the currency with the lower interest rate at 0.50 percent.

Comments

Add New

Write comment
Name:
Email:	do not notifynotify
Title:
	Please input the anti-spam code that you can read in the image.

Comments deemed inappropriate will be removed

3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved."