First Thursday of the month and the Bank Of England has just altered their interest rates (again). The ECB has held their rates (again) and we’ll soon be downing espressos in a vain attempt to stay awake during Trichet’s press conference.

Which reminds me of a conversation I had with a colleague exactly a month ago while trying, and failing, to glean something of interest from that Trichet press conference.

“I’ve never really got the relationship between Interest Rates and FX rates” said the colleague. Sounded like a challenge to me, but when I started to talk about it he immediately cut me off, saying he only had 5 minutes before he had to leave for a meeting.
“Five minutes” says I, “not a bovver guv’ner, I can do it in three”. OK, I didn’t use a fake cockney accent. But hey, this is a post about the link between Interest Rates and FX and opportunities for humour are gonna be limited.

And so I launched straight in.
“Let’s say that you’ve got savings deposited in Bank A and they are giving you interest of 2% p.a. While Bank B just down the road are offering 2% interest as well. You’ve got no reason to change banks, right?”
“Right” says he, eyeing me carefully.
“But” says I, “let’s say the Bank B increases their interest rates to 3%. Now what do you do?”
“Assuming I’m not a lazy b****** I switch my account” says he.
“That’s right, if you weren’t a lazy b****** you would,” says I and move swiftly on before he can acknowledge the oh-so-witty way I turned his comment around.
“But what would happen if Bank B only accepted US dollars, not Euros?” says I.
“I’d convert my money into dollars, then give it to the second bank” says he. He can feel we are almost there and I’m grateful that he doesn’t point out my simplified example is starting to look less realistic than a footballer claiming he moved because of the new club’s great ’s history rather than the oodles of cash.
 
“And if you are putting your money into Bank B, what will everyone else be doing?”
“The same thing.”
“And if loads of people want to convert their money into dollars, or rather if they all want to buy dollars, what is going to happen to the price of the dollar.”
“It’s going to go up” says he, the light of comprehension burning brightly in his eyes.
“You’ve got it” says I. “And as all these people as selling their Euro in order to buy the dollar, the price of the Euro ….”
“Is going to fall” he finishes for me.
“Or to put it properly” says I “the dollar strengthens relative to the Euro.”

He smiles and makes an “Ahhh …” sound as he basks in his new-found knowledge. The five minutes aren’t even up and I return to my laptop, smiling just a little smugly.

“So if the ECB did decide to put up Euro interest rates then the dollar will fall compared to the Euro” says he a few moments later.
“That’s it” says I, not even bothering to look up.

Then I stop to think about it. That smug feeling I mentioned; it is starting to waver.
“Well, not always” says I.
He looks at me in a way that makes it clear he knew there was more to it and he thinks he is just about to be proved right.
“It all depends on expectations” says I. “If everyone already knows that next Thursday the ECB are going to put up interest rates then they aren’t going to hang around. They’re going to buy Euro and sell dollar right now, which will push the dollar down. So the thing that really moves the dollar’s price is a change in what FX traders think will happen to interest rates in the future.”
“And what changes what they think will happen to interest rates in the future?” says he, checking his watch.
“Lots of things,” say I “like inflation figures, or things that a central banker might say. Or you know when they publish the minutes of the Bank Of England’s Monetary Policy Committee meeting, which show how many of the committee voted for a raise and how many didn’t.”

He is still smiling at me as he leaves for his meeting but I suspect the question he hasn’t asked is how can he turn what I’ve just told him into a profitable trading strategy. And the answer is … he can’t.

The feeling of smugness has vanished. That’s the thing about knowing stuff. It’s handy for showing off but sometimes it is of very little use. There’s definitely times when I’d swap a good chunk of what I know for a decent Tuna sandwich!

Here’s hoping the markets’ll be with you,
Z