I have now been trading markets for over 30 years, and am still around making money.

In looking at an exchange rate there are about 10-15 reasons why they go up and down. The problem is that markets place greater or lessor weight depending on how they feel at the time. Money supply in the US was a big deal once, now it is irrelevant. US housing is now the big driver, but who cared two years ago.

So the trick is to figure what is important at the time. Also, in any exchange rate, there are two sides to the debate. In the case of the NZD/USD there are two economic drivers, and they take turns in being important. Some days it is US data, other days NZ data.

My conclusion is that once you have figured out what is going on, it isn’t going on anymore, as the rest of the world has worked it out too. You have to take into account that the world has changed once they work it out and compensate.
You always have to be ahead of current writing, as that is always reporting what has/is happening, not the next move.

Equaly I have no faith in any economic forecasts beyond three months. They are almost always wrong. If a bank economist could regularly get it right, they would not work there.

“if higher interest rates significantly reduce the growth in rental income associated with property, or lower the dividend associated with stocks (or the expected growth in the price of either of these assets), then there may be a case for a ceteris paribus jump in interest rates to lower the value of the currency”

Just thinking it through, if dividends are held constant, and an increase in interest rates leads to domestic investors desiring a shift from shares to bonds, then share prices fall implying that expected returns are higher. What am I missing?

By standard I assume you mean the CAPM right? In the CAPM the effect of the risk free rate on the discount rate depends on the beta of the company involved. Since we are talking about the market as whole we can think about beta=1, in which case an increase in the interest rate will not change the discount rate/expected return.

You’re probably very right that foreign holdings of new zealand assets is focused on interest bearing assets.

However foreigners aren’t the only people who move money in and out of new zealand though. if the risk/return profile of new zealand assets worsens domestic investors might shift towards overseas assets which would result in an increase in the supply of the new zealand dollar, depreciating the exchange rate.

I just don’t think the real story is as simple as UIP makes out since it generally ignores risk and the goods market.

By the way I’m not trying to defend the CAPM, it probably has more problems then UIP!

As to agreement, i totally agree with the conclusion that higher interest rates need not lead to appreciation – that’s what the empirical evidence says.

But I’m still not happy with the explanation. A change in domestic interest rates doesn’t change the risk premium for domestic equities versus foreign rates or foreign equities (assuming no change in domestic share prices) , so I don’t see the currency effect occurring as described. If instead we using a standard model for share prices an increase in the discount rate would just produce an instantaneous drop in the price, but afterwards expected returns would be higher as well.

I agree that the effect your describing is possible assuming that tighter monetary policy leads to either expectations of reduced future company earnings or higher future volatility. The first seems analogous to the argument made sometimes that a increase in short-term rates can lead to a reduction in long-term rates (if investors believe that the Reserve Bank has tightened too much and increased the risk of recession, say). The relative magnitude of the effects still seems all wrong to me though, short-term interest rates should have more of an effect on cash allocation decisions that equity allocation, and foreign holdings of NZ assets are much more concentrated in interest bearing assets than in equities I think.

That was sort of what I was saying. Reducing the risk premium will reduce demand for that asset relative to bills and bonds, and so in that sense we should experience a shift from one type of investment to another. As a result, in this case I think a higher interest rate would increase demand for currency.

The main thing is that higher interest rates need to reduce the yield associated with a given asset for my attempted line of reasoning to work. If higher interest rates only reduce the price of assets, but then don’t reduce the yield associated with the asset we should see a greater quantity of assets being bought (although this depends on the price elasticity of demand for an asset). As a result, if higher interest rates significantly reduce the growth in rental income associated with property, or lower the dividend associated with stocks (or the expected growth in the price of either of these assets), then there may be a case for a ceteris paribus jump in interest rates to lower the value of the currency.

Now both of you know a lot more about this than me, I do realise that I’m just vomiting out my uninformed opinion 🙂 . I don’t think we have significantly disagreed though, but that might be because I don’t know what I’m talking about 😉

About UIP though, I’m positive its empirically unfalsifiable in its most general form, as you have to make an assumption about expectations to test it.