Are the energy markets responsible for the currency mania?

  • US energy prices are significantly lower than those in the rest of the world, a phenomenon that partly explains why the US dollar is so strong.
  • But energy markets aren’t the only factor contributing to the currency craze right now, the failure of some central banks to raise interest rates has hurt other currencies.
  • Australia, one of the largest LNG exporters in the world, has not seen its currency appreciate, showing the importance of central banks.

As mentioned in the last article, the huge break in energy prices between the United States and the rest of the world could explain the extreme strength of the dollar that we have experienced this year.


Part of the problem I have with this is that the corollary of this trade is that energy exporters should benefit from the improved terms of trade. Australia is one of the largest LNG exporters in the world and has seen no appreciation of its currency.


There is another way of looking at currency markets that would better explain this behavior. To generalize, central banks control short-term interest rates, and the market controls long-term rates. When 2-year bond rates diverge dramatically from central bank rates, that’s the market’s way of saying inflation is much stronger than expected, and the central bank needs to do something about it. You can see the market told the Fed to cut to near zero when Covid hit and told them to raise rates since late 2021, which they have now followed.


Australia received the same signal from the bond market, but was much later in raising rates.


Australia generally has higher interest rates than the United States, so this delay in raising rates likely explains much of the currency’s weakness.


So if central bank lagging is driving a currency like the Australian dollar, what does it say about Europe?

We’ll use the German 2-year bond yield (so we can ignore risk spreads) and we can see that the ECB has generally followed the bond market quite closely. But so far this year, they seem to be sleeping behind the wheel.


Switzerland offers a good counterpoint to the ECB by raising rates to match the sell-off in bond yields.


This has led to a substantial appreciation of the Swiss franc against the euro this year.


The irony of the situation is that during the deflationary decades of the 2010s, central bankers spent all their time dreaming up new and innovative ways to try to create inflation. Now that inflation is back, all they have to do is raise interest rates, and they seem to have forgotten how.


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