By now, we all know that in the short run, interest rates and currency valuations are often correlated. In the long term, however, interest rate parity dictates that a country’s currency should move in the opposite direction as its domestic interest rates, in order to guarantee that investors in different countries receive comparable returns. This is consistent with financial economics, in that higher-yielding securities tend to elicit less demand, which means that the corresponding currencies sag due to insufficient capital inflows. Now, let’s apply this theory to the recent downgrade of Italy’s public debt. This downgrade will drive Italian interest rates higher as risk-averse investors flee Italy in search of safer investments. (Bond prices and interest rates move in opposite directions) The resulting capital outflows would cause the Italian currency (if it still existed) to depreciate. Fortunately for Italy, the capital outflows it suffers will be spread across the entire Euro-zone, and the net effect on the Euro will be negligible.

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