Capital market horizon

Currency exchange rates are more than simple interest-rate differentials. Two other factors come into play here, one relevant and one not particularly so.

Trade flows between the UK, Switzerland, and the Eurozone are not in the sort of persistent imbalance seen, say, between the U.S. and China or the U.S. and Japan. Accordingly, we can dismiss this as a major factor in exchange rates out of hand.

The relevant factor is returns in capital markets. Indexing the yields to maturity on Swiss, British, and Eurozone 10-year notes since the January 1999 advent of the EUR shows there were wide differences well into mid-2002. These differences widened slightly in 2005 as British yields remained firm and the GBP short-term FRR increased relative to that of the EUR, but then converged once more. By late 2006, yields at the 10-year horizon had converged. If returns on capital are similar and the mobility of labor and other factors of production throughout Europe is high, why should currency exchange rates be volatile on either a realized or an implied-forward basis?

The harmonic convergence of asset returns, currency volatility, and monetary policies creates something of a virtuous cycle in European markets. The convergence of asset returns and parallel monetary policies reduces currency volatility. This reduced volatility in turn lowers the liquidity premium bond investors demand to protect themselves against currency volatility; yield curves around the world have flattened in part because of this factor.

This whole state of affairs is rather extraordinary: In a nominally floating exchange-rate world, the construction of the EUR led to a de facto return to the stable exchange rates prevailing prior to the dissolution of Bretton Woods in the late 60s and early 70s.

The “firm” exchange-rate environment predicted in the December 2005 article is, in fact, coming to pass.