Rate differentials regain focus – Commerzbank

Commerzbank’s Antje Praefcke notes that the Dollar has benefited from safe-haven demand as the war in the Middle East weighs on sentiment, pushing EUR/USD below 1.15. She argues that, beyond volatility, interest rate differentials and real interest rates could regain importance for exchange rates in coming weeks, with falling real rates generally seen as negative for a currency.

War, yields and Dollar safe-haven bid

“Certainly, aside from this week’s central bank meetings, news surrounding the war in the Middle East continues to dominate the foreign exchange market. As always in such uncertain times, the dollar is the ultimate safe haven, which is why EUR/USD fell below 1.15 and is now trading around this level. And as always in such uncertain times, volatility is high, especially since conflicting reports from opposing sides make it difficult for the markets to interpret the situation.”

“I just want to point out one aspect that, alongside increased volatility, could become more relevant for exchange rates in the coming weeks the longer the war drags on and energy prices remain high: interest rate differentials and real interest rates.”

“Central banks could now find themselves in a similar situation again. It is still too early to expect the Fed, ECB, and others to begin adjusting their key interest rates just yet. They will all primarily point to the risks to inflation and growth.”

“In the event of a short war, however, central banks would assume that energy prices would stabilize again and look past the price shock, labeling it as temporary, which would lead to an adjustment of interest rate expectations – some of which have already run far ahead.”

“Nevertheless, the market is likely to keep a very close eye on interest rate expectations and the trend in real interest rates. This is because a falling real interest rate (due to rising inflation rates while key interest rates remain steady or possibly fall) is generally negative for a currency.”

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)