Analysing the data, it can be seen that the currency pairs with the largest difference between interest rates and inflation had the greatest potential to change in value. Central banks examine the former by taking into account current inflation, the economy's level of debt relative to its size and the level of unemployment. What can we learn from the current data?
Inflation and interest rates
Analysts agree that in 90% of the world's major economies, we could see inflation fall by the end of the year. However, in only 33% of these economies would interest rates remain unchanged or be cut at the end of this year. The largest decreases in inflation are expected by analysts: in Turkey (by 30 percentage points), Hungary (by 18 percentage points), Poland (by 9.6 percentage points) and Sweden (by 8.3 percentage points). However, it should be noted that inflation in these countries is coming down from much higher levels than in, for example, Germany or France.
Source: https://www.ecb.europa.eu/stats/macroeconomic_and_sectoral/hicp/html/index.en.html
The difference between inflation and the level of interest rates is as important as the fall in inflation. In a general sense, the mechanism of interest rates is simple - central banks raise interest rates when inflation rises above expectations, which reduces demand and usually leads to a fall in price dynamics. The other way it works similarly - interest rates that are too high can lead to a collapse in domestic demand and the onset of a recession, prompting central banks to lower interest rates to boost demand in the economy.
Currently, the largest expected interest rate rises of 75 basis points are expected in the euro area, New Zealand and Denmark. Increases of 50 basis points by the end of the year are expected in Switzerland, Norway, Israel and Turkey. These factors are likely to strengthen the currencies of these countries.
Analysts' consensus is that we could see rate cuts by the end of the year in individual economies such as Hungary (400 bps cut), Singapore (28 bps cut) and Mexico (25 bps cut).
Analysing these two issues, it would seem that currency pairs in which the base currency raises interest rates and the quoted currency lowers them have more potential to rise. Conversely, pairs in which the base currency lowers interest rates and the quoted currency raises them have less potential to rise. Nevertheless, the euro to Hungarian forint pair is falling. It seems that in this case the factors of expectations of falling inflation are more important.
Source: Tradingview
The opposite is true for the euro-Singapore dollar pair, where inflationary factors are no longer as significant as for the Hungarian economy.
Source: Trafingview
Expected Real Interest Rates
From the example cited earlier, it can be seen that an additional inflation factor must be taken into account when analysing currency movements. Interest rates minus inflation are the so-called real interest rates. Currently, we can see the lowest real interest rates for Turkey (minus 46%), Hungary (minus 12.4%), Poland (minus 11.6%) and Sweden (minus 9%). Only 19% of the economies experienced positive real interest rates.
The largest increases in real interest rates are expected by analysts for the same economies currently facing the largest negative real interest rates such as Turkey (up 30 percentage points), Hungary (up 13.9 percentage points), and Poland (up 9.6 percentage points). Declines in real rates are expected for the Chinese yuan (minus 1.7 percentage points), the Hong Kong dollar (down 0.5 percentage points) and the Japanese yen (the smallest increase of 0.8 percentage points).
By analysing these factors, it is possible to see that the currency of a country where real interest rates are rising may strengthen compared to the currency of a pair where real interest rates are falling. The currency pair Polish zloty to Japanese yen, for example, may appear attractive in this context.
Source: Tradingview
Grzegorz Dróżdż, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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