Over the past 6 months, the Euro and Pound Sterling have risen steadily in value against the USD. Labor and market reforms are forcing European companies to become more competitive. Hence, the economies of Britain and the EU are finally beginning to show signs of life. While economic fundamentals have certainly contributed to currency appreciation, they must take a back seat to interest rate differentials in any analysis of currency markets. Economists reason that interest rate differentials represent a leading indicator for foreigner’s willingness to continue financing the US current account deficit. That is, if US capital markets can continue to offer foreigners attractive returns, then they will continue to park their savings in the US.

Ben Bernanke, Chairman of the US Federal Reserve Bank, recently announced that the Fed is approaching the peak in the current interest rate cycle. It has raised interest rates more than a dozen consecutive times over the last two years, and may finally have achieved a point of balance, whereby growth is neither restrained nor excessive. Inflation has reared its ugly ahead, driven by rising food and commodity prices, but American consumers have learned to adapt.

Meanwhile, the Central Banks of Britain and Europe have independently begun to tighten money supply in order to preempt inflation. Most economists expect them to hike rates several times over the next 6 months, which will narrow the gap between American and European interest rates. This could be bad news for the US. For many years, OPEC nations and the Asian exporting nations have ‘threatened’ to diversify their forex reserves out of USD-denominates assets. They may finally have the impetus they need, because now they can earn attractive returns in Europe, whereas before they were limited to American securities. In short, foreigners may soon become far less willing to lend to and invest in the US if they can earn comparable returns (without sacrificing stability) in Europe. In such a scenario were to be realized, the result would surely be a weaker USD.