A brief look at recent history

At first sight, it is clear that interest rate differentials increase the number of transactions in the market. Clearly, gaps between the interest rates of different central banks create opportunities which are exploited vigorously by speculative actors of all kinds. But at the same time, we know from experience that the widening gap between emerging market and developed market interest rates was coupled with a decrease in forex volatility, as part of the so-called and by now disproven Great Moderation discussed by some economists. This is partly due to the fact that rising liquidity causes lower volatility. But the relationship between increasing liquidity, and a widening gap between interest rates is not that well understood. First of all, since interest rates and risk perception are closely related to each other, it is counter-intuitive that a rising interest rate gap between nations would result in lower volatility, and lower risk perception among market participants. We can illustrate this better by making an analogy with the interest rate gap between bonds of investment grade firms and speculative grade junk bonds. When this spread widens, it is coupled to increasing volatility in the bond market. During the same period when the widening gaps in interest rates among nations led to reduced forex volatility, reduced volatility in the corporate bond market was coupled with a contracting gap between the bonds of speculative and investment grade firms. Clearly, there is some discrepancy here.
A way of explaining this is by separating the period between 2000 and 2007 into two phases. The first phase was dominated by falling interest rates around the world, initiated by Alan Greenspan’s choice to bring the rates down to 1 percent and keeping them there until they were raised by Ben Bernanke four years later. During this period, volatility came down from higher levels as dormant money found its way to stock markets and other kinds of investments around the world. During the second part of this era, again initiated by the US Fed, interest rate gaps actually widened, but there was no corresponding rise in longer term forex volatility, apart from a few blips that occurred, for example, in February 2007. Was it then a sign of the coming turmoil in 2008 that these widening gaps between emerging markets and developed economies were not reflected in the forex market? We would argue that it was. For one, the rise of inflation has almost always been coupled to a subsequent cooldown period, or even recessions in all economies. No economy can afford to run at full speed in an inflationary environment. And since many emerging markets were raising rates to fight inflation in this period, historical experience strongly suggested that a period of slowdown was likely which would have necessitated a rise in volatility, as it often happens. But market participants refused to adjust themselves in accordance with this fact, driving the currencies of emerging markets higher, being content with lower risk premiums, until volatility returned with a vengeance in a series of events that all of us are familiar today culminating with the Lehman bankruptcy, and its aftermath.