Two competing forces in FX markets: Interest Rate Parity and Hot Money
Interest Rate Parity states that a lower yielding currency should appreciate relative to a higher yielding currency. According to the International Fischer Relationship, higher yielding currencies have higher inflation domestically. This inflation difference causes the high yielding currency to depreciate relative to a lower yielding currency.
An alternative force is hot money.
- Hot Money = Change in foreign exchange reserves – Net exports – Net foreign direct investment
These are the yield chasers. Higher yield means higher returns, so the high yielding currency apprciates. Investors who chase yield invest so called “hot money”, that will vamoose once yields elsewhere are higher. A country heavily dependent on Hot Money (see: Germany 1928-9) may see wild fluctations in capital flows. See the following excerpt from Lords of Finance…:
Hot money is tough to measure, but it is considered a yield seeking activity. If yields start to rise, money will flood from US equities to bonds, depressing equities. For now, a glut in supply stemming from a fiscal expansion is keeping US yields low.