Interest Rate Outlook for 2012

Currency traders look to many indicators in an attempt to form a view for future exchange rate movements. These usually include GDP and employment rates together with other factors providing feedback on the overall health of the economy. Traders pay particular attention, however, to interest rates as a change in a jurisdiction’s interest rate usually has a direct impact on exchange rates.

Typically, when interest rates go up, so too does demand for assets denominated in that currency. This increased demand usually leads to a gain in the value of the currency. Conversely, a decrease in interest rates often leads to a currency sell-off and may force a devaluation in the currency.

The correlation between interest rates and exchange rates is well established and if it appears likely an interest rate change is imminent, currency traders are bound to consider the potential impact on currency rates. So, with that in mind, here is a look at possible exchange rate actions for several of the major currencies:

The U.S. economy improved in the second half of 2011 but the Eurozone debt crisis poses a risk to the global economy.

The U.S. economy realized positive growth in each of the first three quarters of 2011. Employment also made respectable gains with the unemployment rate falling to 8.6 percent in November compared to 9.2 percent unemployment in July.

While modest, these improvements have led to a sense of optimism but leave it to Fed Chairman Ben Bernanke to maintain perspective. In late September, Bernanke referred to unemployment as a “national crisis” and continues to warn that unemployment will remain “elevated” for at least another year.

In addition, Bernanke has highlighted the European debt situation as a threat that could very quickly reverse the recent gains. In mid-December, Bernanke met with a group of Senators and used the opportunity to warn that the Eurozone situation will likely deteriorate in 2012 and the repercussions will certainly be felt in the U.S.

Given the Chairman’s stance and his earlier pledge to maintain the current record-low interest well into 2013, there is little reason to expect a change in the Federal Funds rate for 2012.

The European debt crisis is spreading well beyond Greece and is now threatening the larger economies.

As 2011 draws to a close, the outlook for the Eurozone has taken a dramatic turn for the worse. The debt contagion has undoubtedly spread beyond Greece with Ireland, Portugal, Spain, Italy, and even France – the region’s second-largest economy – now at risk. At the very least, some painful remedies will be necessary to address sovereign debt levels, the implementation of which will contribute further to the deterioration of several European economies.

In addition, the European Central Bank introduced back-to-back interest rate cuts late in the year to lower the benchmark rate to 1 percent. During the same time period, the European Commission reduced its growth outlook for the year, lowering growth projections for 2012 from 1.8 percent growth, to just 0.5 percent – and some people feel that even this revision is too optimistic. Unemployment is also expected to rise as government spending cuts kick in and several European countries find themselves with no choice but to slash expenditures to reign-in deficits.

Given these challenges, it is difficult to see how the ECB can entertain serious thoughts of a rate increase until conditions improve. If anything, the chance of an additional rate cut early in the new year seems far more probable.

The Bank of England slashes the 2012 outlook ahead of wide-spread government spending cuts.

While not officially part of the Eurozone, Great Britain’s future is very much tied to the fate of those countries sharing the euro. Like the Eurozone, Great Britain faces a staggering debt accumulated from years of deficits and now has no option but to sharply reduce total government spending.

A considerable portion of these spending cuts will come in the form of government job losses that will push the unemployment rate considerably higher during the course of 2012. This will lead to a further pullback in spending causing growth to slow more than originally anticipated. As a result, the Bank of England has reduced its growth outlook for 2012 to 1 percent growth, from 2 percent estimated earlier.

Bank of England Governor Mervyn King defended the revised outlook suggesting that without the Bank’s efforts to stimulate the economy through low interest rates and a bond purchase program to inject cash into the economy, the decline would be even worse. Given this, it seems unlikely we will see an interest rate increase until the economy shows considerable improvement.

Increased competition from other Asian countries and a strong yen places Japan’s export sector at risk.

Japan’s economy is tied directly to exports. Initially, Japan grew to dominance by providing a low-cost manufacturing center but as the country’s expertise expanded and the workforce became more skilled, the cost advantage diminished over time. In more recent years, China and other Asian countries have become direct competitors to Japan.

Japan’s export business also benefitted from a favorable exchange rate with other currencies, particularly, the U.S. dollar. By the late 1970s, the U.S. accounted for an ever-greater share of Japan’s export market eventually becoming Japan’s largest export destination until being recently surpassed by China. Still, the U.S. bought just under $100 billion worth of goods in 2009 but future sales could be impacted as the yen continues to gain on the dollar.

In mid-2010, one U.S. dollar could buy just under 94 yen but the dollar has weakened considerably since then and as of late December, one dollar was worth only about 77 yen. This represents a loss of roughly 22 percent in the space of six months thereby making Japan’s products significantly more expensive for U.S. consumers.

For these reasons, it is very unlikely that the Bank of Japan will raise rates thereby risking further appreciation of the yen. In fact, during the second half of 2011, the Bank engaged in the selling of hundreds of billion of yen in an attempt to over-supply the financial system and reduce the value of the yen.

Weaker demand for Canadian exports eases the need for an interest rate hike.

At one point during 2011, the Canadian economy was growing well in excess of the Bank of Canada’s 2 percent annual growth rate target. Bank of Canada Governor Mark Carney even went on record suggesting that easy access to cheap credit was to blame for both the inflation creeping into the economy and the increased level of debt held by Canadian households.

It certainly seemed that with these comments, Carney was prepping markets for an increase in interest rates, but it was not to be. By the beginning of the 4th quarter, it was obvious to all that growth was declining and is expected to shrink further as the debt crisis in Europe becomes more of a factor in 2012.

Responding to the new reality, the Bank of Canada has cut growth projection for 2012 from 2.6 percent growth to 1.9 percent. Note that this is just shy of the top end of the Bank’s target which makes the need for a rate hike less urgent. If growth does expand more than expected in 2012, a rate increase is likely but this could be several months in the making and is not an immediate concern heading into 2012.

Further rate cuts could be coming early in 2012 if Australia’s export sales continue to decline.

While most other jurisdictions were cutting interest rates down to record lows and then holding them there, Australia was doing the opposite. For the first three quarters of the year, the benchmark rate was maintained at 4.75 percent but two quick quarter-point deductions in October and December reduced the bank rate to 4.25 percent.

These moves by the Reserve Bank of Australia were preemptive in nature as it became obvious that Australia would not be able to remain immune to global forces. Weaker demand for resources in Europe and most especially China, resulted in a considerable loss of sales and this is expected to become even more of an issue in 2012.

The RBA has already hinted that further rate cuts could be coming in the early part of 2012.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.