Uncovered Interest Parity
By Arnold Kling
U.S. interest rates are low relative to those of other major countries (save Japan).
Where is my uncovered interest parity?
Here is what Brad is thinking. If I own dollars today and want to invest in bonds that will pay me in dollars tomorrow, there are two ways that I might do so. (1) Buy U.S. bonds denominated in dollars.; or (2) Buy European bonds denominated in euros and in ten years convert the euros back to dollars.
The choice depends on the combination of the interest differential and the expected change in the exchange rate. For example, if I knew that the exchange rate were going to stay fixed for ten years, then I would simply buy the bonds with the higher interest rate. Conversely, if the interest rates were identical, I would buy the bonds whose currency is most likely to appreciate.
Brad is saying that interest rates on European bonds are higher. So, investors must be expecting the dollar to appreciate (slightly) over the next ten years. Yet Brad believes that the dollar has to fall significantly, and probably soon, to reduce our trade deficit.
I think that the main issue here is that compared with the markets, Brad and other economists believe much more strongly that the trade deficit means that the dollar is over-valued. This difference in beliefs is nothing new. Perhaps the markets know something that economists are overlooking. If the economists are right, then foreign securities are a bargain.
For Discussion. If you believe the economists, but you think it could take a long time for markets to correct, what financial strategy should you use to take advantage of the over-valued dollar?