While interest rates in the U.S. have fallen so far year-to-date, we continue to believe that rates may be poised to rise in the second half of 2014. Over the last several weeks, we have seen increased interest from clients about how best to prepare their portfolios for an eventual rise in U.S. interest rates. While many investors understand the direct implications rising rates will have on their bond portfolios, one less-probed topic stems from what impact rising rates will have on the value of the U.S. dollar. With the increased popularity of currency-hedged equity strategies, the impact that currencies can have on investor total returns is beginning to crop up on more investors’ radar. In the remainder of this piece, we will examine the historical relationship between interest rate differentials between countries and the impact on their exchange rates.

Although interest rate differentials are only one potential determinant of the value of a currency, we believe that rising rates in the U.S. will ultimately lead to an appreciation of the U.S. dollar against a basket of low-yielding developed market currencies. As shown in the tables below, rising interest rates have tended to support currency appreciation compared to lower-yielding currencies. While the relationship is far from linear, the graphs do show that as interest rates (represented by the shaded portion) in the U.S. rise compared to foreign interest rates, the value of the dollar (represented by the black line) tends to appreciate. Interestingly, as rates have fallen so far this year, the dollar has also weakened marginally against a large number of foreign currencies, particularly in emerging markets.

Interest Rate Differentials and Exchange Rates, 12/31/03–5/31/14

U.S. & Eurozone: 2-Year Interest Rate Differentials vs. Exchange Rates

U.S. & Britain: 2- Year Interest Rate Differentials vs. Exchange Rates

U.S. & Japan: 5-Year Interest Rate Differentials vs. Exchange Rates

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