Interest rate differentials on the move

After nearly two years of relentless selling in the U.S. dollar vs. the euro (from a low of 85 cents for the euro in January 2002 to the February 2004 peak of $1.29), dollar bears have gone into temporary hibernation.

The euro/dollar rate shifted into a sideways range in mid-summer, trading between $1.24 and $1.19through late September. Accompanying this shift from aggressive dollar selling to sideways consolidation was an important change in U.S. monetary policy.

Analysts say this has signaled the start of a new trend in interest rate differentials. Interest rate differentials refer to the spread between the interest rates being paid on two different currencies. For example, an investor who plops money in a British account has been earning a much higher rate than a U.S. savings account, simply because of the firmer British rate environment.

Over the last several years, the U.S. Federal Reserve has aggressively slashed the Federal Funds rate to a 45- year low, hitting 1-percent in June 2003. This made dollars fairly unattractive to foreign investors.

Responding to signs of faster economic growth and potential inflation, the Fed shifted gears this summer and initiated the first rate hike since May 2000. A second rate hike came at the August meeting and a third tightening occurred on Sept. 21, bringing the Fed Funds rate to 1.75 percent.

The Fed is largely expected to continue its tightening policy into 2005 to return the Fed Funds rate to a more neutral level. The remaining meetings this year are on Nov. 10 and Dec. 14.

“We are seeing the beginning of a global normalization of interest rates,” says Kathleen Stephansen, director of global economic research at Credit Suisse First Boston. “For the last two to three years, we have seen abnormally low levels of interest rates. Rate levels around the globe had to adjust lower to reflate the global economy. Now, central banks feel that it’s time to take away the extraordinary supply of liquidity.”