Reading about the market reaction to Bernanke's comments on a
possible end to monetary stimulus, I was interested to note the appreciation of
the dollar being generally attributed to associated expectations of a rise in dollar
short rates.
Whilst this may indeed be the case in this instance, it's a good opportunity to
highlight that there are two quite distinct reasons why we might expect an
announcement on asset purchases to have this effect on the exchange rate. It would be quite reasonable to expect an exchange
rate impact, even if expectations of short term interest rates remained anchored. The mechanics behind this are closely related to the way I have looked at Modelling QE.
For this type of analysis, it can be useful to think in
terms of expected single period rates of return. To simplify, we can think in terms of two
asset classes: deposits, carrying a short rate of interest and bonds with a
long rate. For our single period, the return
on deposits is known, but the return on bonds is not, because the latter depends
on how the bond price changes in the period.
We therefore need to use an expected return, based on what the bond
price is expected to be at the end of the period.
In the simplest models, the actual return on deposits and
the expected return on bonds will be equal.
The assumption is that if they were not equal, investors would keep
trying to switch their portfolios until the change in demand drove the expected
returns into line.
This assumes that the two assets are perfect substitutes,
but in reality there are plenty of reasons for believing they are not. More sophisticated models will recognise that
the two rates will typically be different.
The difference might be attributed to a liquidity premium or a term
preference. For convenience, I am going
to call the excess of the expected single period return on bonds over the short
rate the term preference (noting that this value could be positive or negative).
The important point
here is that the size of the term
preference is a function of demand and supply.
For whatever reasons (often institutionally), there will be some
investors that want exposure to long term rates and some that want exposure to
short term rates. At the same time the relative supply of short term and long
term assets may vary (through QE for example).
This is going to change the value of the term preference.
We can extend this analysis to the long term. The expected long term return on bonds will be
the compound of all the expected single period returns (that is, all the future
returns expected now). The expected long
term return must equal the actual return (if a Treasury yields 2% to maturity
and I expect it to yield 3% to maturity, I'm clearly mistaken). In which case, the actual yield on bonds is
equal to a compound of:
1. all the expected short term rates from now until the bond
maturity; and
2. all the expected values of the term preference from now
until the bond maturity.
where, in each case, expected means expected now.
So, when the bond yield changes, it may represent a change in expectations of future short
rates, or it may represent a change in expectations of the term preference, or
maybe a combination of both. However, whilst
it's possible that a change in asset purchases might not result in any changes
to the actual short rate, it is highly unlikely that it will not lead to any
changes in the term preference, as that would imply that investors were indifferent
between long and short rate exposure.
Therefore, where the bond yield changes in response to an announcement on asset purchases,
we know for sure that the expected value of the term preference has changed,
but we don't necessarily know what it implies about the expected course of future
short rates.
This has all been about changes in the domestic term
structure. How does this relate to the
exchange rate? The important point here
is that what matters to the exchange rate is not just the short rate on
deposits, but also the expected single period rate of return on bonds. If investors with long-term rate preference invested
exclusively in the domestic market, then this might not matter. However, this does not appear to be the case;
cross-border holdings of long-dated securities are substantial. The demand and supply for these assets (which
has immediate impact on the exchange rate) depends on the single period expected
return on long assets, not on the short rate.
In conclusion, an announcement on asset purchases may do two
things: it will definitely have an effect on the term preference; but it may
also have an effect on expectations of short term interest rates. These two effects are quite distinct, but
both will have an impact on the exchange rate.
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