LIVE MARKETS-Real rate differentials matter more for FX, for now

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REAL RATE DIFFERENTIALS MATTER MORE FOR FX, FOR NOW

The traditional relationship between currencies and relative nominal interest rates has broken down since the Iran war began, with traders focusing instead on the impact of higher energy prices on terms of trade.

But if you look at real rate differentials -- i.e. inflation adjusted -- Goldman Sachs point out, the traditional relationship holds up rather better, with lessons for how to trade other supply-driven inflation shocks.

Normally currencies react strongly to relative moves in nominal interest rates, but while European rates rose more dramatically than U.S. ones in March as investors priced more aggressive responses from European central banks than the Fed, the dollar strengthened on most European peers.

Since then, the euro has rebounded while rate differentials stayed broadly steady, and in all, since the war began, the relationship between rate differentials and currency moves has turned negative.

When you think about it, that makes sense. The reason traders are pricing in ECB and BoE rate hikes is because their economies are more exposed than the U.S. to energy shocks, and hence also more exposed to energy-driven inflation.

And, Goldman say, "those energy vulnerabilities manifest as a currency-negative through a deterioration in terms of trade, and that pushes in the opposite direction to the usual FX-positive channels of repricings higher in yields."

But they say if you look at real yields, which take out the inflation effect, the correlation between relative rate moves and currency moves actually holds up quite well, certainly for euro/dollar.

So should we always think about real not nominal rates for FX moves?

Well Goldman say not really, it all depends on the type of inflation.

"Higher domestic inflation pricing can either represent firmer domestic aggregate demand - a currency-positive - or either lower supply or higher inflation premium/uncertainty - both of which are typically currency-negatives."

"The different prevailing regimes help to identify which of these dynamics is dominating."

They also say their analysis since the war shows that at times when markets are not being led by energy prices, the traditional correlations hold up.

That means, should we get a surprise at a central bank meeting next week, expect a 'normal' FX response.

(Alun John)

EARLIER ON LIVE MARKETS:

EUROPE'S ECONOMIC MOMENTUM IS FADING FAST CLICK HERE

WEAK OPEN, MARKET RECOVERY ON PAUSE CLICK HERE

EUROPE BEFORE THE BELL: STOCKS SET FOR DROP, HEADING FOR SHARP WEEKLY FALL CLICK HERE

IRAN FLAUNTS ITS GRIP, INVESTORS COWER CLICK HERE