The standard three-month non-deliverable forward can be described in large part as a short-term interest rate arbitrage. The buyer of the JPY is borrowing the USD, selling the USD, and buying the JPY at the spot rate and then lending the JPY. In three months, the trade can be unwound or rolled over for another three months. The rollover rates can be locked in using forward rate agreements; this is why the forward rate ratio (FRR) for various currencies’ LIBOR over the six-nine month horizon is such a useful tool. This FRR is the rate at which borrowing costs can be locked in for three months starting six months from now, divided by the nine-month rate itself. The more the number exceeds 1.00, the steeper the yield curve; numbers less than 1.00 indicate inversion.

The USD FRR6,9 fell sharply in the two years of Federal Reserve tightening beginning in mid-2004. By contrast, the FRR6,9 for both the EUR and JPY steepened beginning in June and November 2005, respectively. All else held equally, we should think the flatter USD money market curve would support the greenback in 2006 as it did in 2005. But all else is never held equal.