How do interest rates drive the rand?

In last month’s column we looked at the fundamental theory regarding gold prices and how this drives the rand – whereas when we look at the historical correlation, this theory has very little credibility. Let’s take a look at another fundamental study – interest rate changes and their effect on exchange rates. This widely accepted fundamental theory is as follows: If an economy raises its interest rates, its currency will strengthen because the higher interest rates attract more foreign investor flows to take advantage of this higher return. So when the Reserve Bank increases interest rates or the US Federal Reserve decreases rates, the rand should strengthen against the dollar. Conversely, when SA interest rates are reduced or US interest rates increased, the rand should weaken. Makes sense in theory, right? But what is the reality? The inserted chart reflects the historical dollar/rand exchange rate since 1970, together with the differential between SA and US prime rates, colour-coded with positive (green), negative (pink) and negligible (white) correlation. Below this is the 20- day rolling correlation as well as a five-year moving average. Once again, this paints a very revealing picture. What this Chart is telling us is the following: Historically, the past 43 years have shown periods of both positive and negative correlation, as well as periods of no correlation or virtually none at all. The average correlation for the whole period is 40% – which is not a high correlation. Furthermore, it is a positive correlation, which means that the rand has tended more to weaken when rate differentials have increased, and strengthen when rates have decreased – exactly the opposite of what is generally accepted! The 200-day rolling correlation (blue area) clearly shows the periods of both positive (above zero) and negative (below zero) correlation, with the five-year moving average (red line) showing the positive bias (on average 27% correlation). Highs and lows in the exchange rate have tended to lead (not lag) interest rate differential highs and lows in more recent years. Once again, a fundamental theory, once put to the test, has failed miserably. In reality, there is no consistent historical correlation between interest rate differentials and exchange rates. www.ForexForecasts.co.za/ go/ZAROutlook