By Erik Norland
Interest rate differentials between currencies can be crucial in foreign exchange markets for pricing purposes such as in the carry trade, and they have taken on added significance with the advent of negative rates in Europe and Japan over the past few years. So, how big are the interest rate differentials between currency pairs? On the face of it, it seems like a simple enough question. But the variety of ways used to measure the differential makes for a complicated answer. Differences in rates between central banks can be used as a guide but may be of limited value to everyday currency traders as only major financial institutions deal directly with central banks.
In financial theory, market participants would typically look at interbank rates, such as ICE LIBOR, as a guide. Unlike the official central bank rate, interbank rates offer a look at private sector lending rates. However, these rates may not reflect the rate differentials that currency traders are actually getting in the market. Also, the rates have been discontinued for several currencies.
Overnight index swap rates (OIS) such as EONIA can also be used to gauge the level of interest differentials among currencies. OIS rates, however, stick closely to central bank rates and may also not fully reflect the interest rate gaps currency investors are getting in the market.
Another avenue for calculating interest rate differentials is the currency market itself, where implied interest rate differentials can be calculated from the difference in the value of a currency in the spot and futures markets. For example, CME’s FX Swap Rate Monitor calculates the implied interest rate differential between CME FX futures and CME FX Link’s central limit order book (Figure 1).
Figure 1: FX markets shows larger interest rate differentials than other measures
What’s curious is that when these ways of measuring interest rate differentials are compared, the currency market measure consistently showed a larger interest rate gap between the US rate and the foreign currency rate than did central bank rates or the OIS. In other words, US interest rates appeared higher relative to other countries when observed in the currency market than in the interest rates market. This was true across seven different currencies on CME FX Swap Rate Monitor measured over August and September. Some of these gaps were as big as 20 or 30 basis points. This is to say that US dollar rates appear to be relatively higher versus rates in Australia, Canada, the eurozone, Japan, New Zealand and Switzerland than the differences from central bank rates or OIS would suggest.
For some currencies, like the Australian (AUD) and New Zealand dollars (NZD), the gap between the currency market and the OIS rate differentials are fairly small, averaging around 10 basis points (bps). For most of the other currencies, the gap is more substantial, averaging around 20-25bps for the euro (EUR), British pound (GBP), Canadian dollar (CAD) and Swiss franc (CHF). For the Japanese yen (JPY), the rate gap between the currency market and the OIS measures has been larger (around 35 bps). In every case the currency market measure shows US rates being higher relative to the other countries when compared to the central bank rate or OIS measures.
For EUR, GBP and JPY, the interbank (ICE LIBOR) rate measure is closer to the FX Currency Swap Monitor measure. Even here, however, the currency futures market measure shows that the EUR-USD interest rate differentials were, one average, 5 bps greater than the interbank measure and 14 bps greater in Japan. By contrast, for the UK, those two values have been in line over the past two months (Figure 2).
Figure 2: OIS comes close but still shows smaller rate differentials than FX markets
The seven currencies mentioned share one thing in common with the US dollar: they all have official central bank rates near zero. Among the currencies on CME’s FX Swap Rate Monitor, only the Mexican peso has interest rates substantially above zero – in the 4-5% range. For the Mexican peso as well, the currency market measure showed US rates on average 50 bps higher relative to Mexican rates than is the case in the OIS market and about 24 bps higher than the two nations’ central-bank rates would suggest (Figure 3). This difference probably arose from the fact that the Mexican central bank cut rates twice over the past two months which was anticipated by the currency forward markets but not by overnight swap rates.
Figure 3: In Mexico, too, USD rates appear higher than they do for the other currencies
As one can see in the appendix (Figures 4-11), the day-to-day values are a bit choppier than the averages, but even so, the currency market mostly shows a greater gap than the other measures. So, this begs the question: Why would the currency market imply that US rates are higher relative to other country’s rates so consistently and across so many currencies than would be implied from the differentials calculated from interbank or central bank rates?
One answer is that the relatively higher US rates implied in the currency markets might reflect a global forward demand for U.S. dollars. In certain cases, like in Japan and the UK, it might also reflect expectations that their central banks may soon be lowering interest rates. That said, if that expectation does exist, it should, in theory, also exist in the interbank rates but should only be seen in the OIS market in the 24 hours before a rate move.
One thing is clear, those who trade in the currency markets and those who work in short-term interest markets might want to keep a close eye on the interest rate differentials implied between currency futures and the spot FX market as an additional reference point in their trades.
Figure 4: EURUSD Rate Differentials
Figure 5: GPDUSD Rate Differentials
Figure 6: JPYUSD Rate Differentials
Figure 7: AUDUSD Rate Differentials
Figure 8: CADUSD Rate Differentials
Figure 9: CHFUSD Rate Differentials
Figure 10: NZDUSD Rate Differentials
Figure 11: MXNUSD Rate Differentials
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