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Interest Rate Parity, is too often overlooked by commentators!

Increasingly we are faced with a barrage of media reports around interest rate movements by the Central Banks and all the doom and gloom scenarios whilst some would offer comfort around Australia's own long-term stability and low rates. The view is often around domestic growth, employment and inflation.

For a long while, I cannot recall a single article or analysis referring to the theory of Interest Rate Parity. It is a critical theory that is a key driver in interest rate decisions. In-country variables do determine interest rates but in reality interest rates also operate in tandem with global markets often through the Interest Rate Parity model.

The Corporate Finance Institute has a good article on this and an extract from this is "...The theory holds that the forward exchange rate should be equal to the spot currency exchange rate times the interest rate of the home country, divided by the interest rate of the foreign country."

In a nutshell, the model shows that interest rates and exchange rates always dance together if not always coordinated

. As an example, if one country's interest rate is too high relative to another, then the market will adjust the exchange rate to adjust for arbitrage opportunities.

There is a mathematical model that illustrates the mechanism but to put it simply, if the US Fed goes helter-skelter on rates, Australia by default will have to accommodate that either through similar interest rate moves or the market will adjust exchange rates.

What this means is that contrary to what some may believe, when the US Fed makes or signals interest rate changes, other markets, including Australia will tend to synchronise either with interest rates or exchange rates. We do not operate in isolation !!!

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