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Compare Real Yields to Judge Which Currency Offers More

Country A has a policy rate of 5.0 percent and inflation of 6.0 percent. Country B has a policy rate of 3.5 percent and inflation of 2.0 percent. Which currency looks more attractive to a yield-seeking investor, other things equal?

Compute the real rates. Country A: 5.0 minus 6.0 is minus 1.0 percent. Country B: 3.5 minus 2.0 is plus 1.5 percent.

Despite the lower nominal rate, Country B offers a real return 2.5 percentage points higher. An investor holding Country A's currency loses purchasing power at a rate of 1 percent a year in real terms, while the holder of Country B's currency gains 1.5 percent.

This helps explain why high-nominal-rate currencies with high inflation often weaken. Investors see through the headline.

Now caveats. Inflation expectations matter more than current inflation. If Country A's inflation is falling quickly and the central bank is credible, the real rate may be rising, and the picture changes. If Country B's inflation is expected to rise, its real rate may fall.

Also account for risk. Higher inflation countries often carry political and credit risks.

Try a quick version with the forward-looking rate: use expected inflation over the next year in place of the current figure. The ranking can change.

The exercise is a first filter for carry candidates: nominal yield alone is a poor guide.

Your turn: compute real policy rates for the central banks of three pairs you follow.

Clear example. In practice we would also look at which inflation measure is used and which way it is moving. A country at minus 1 percent real rate with inflation falling fast may see its real rate turn positive within a few months, while the other one could be heading the opposite way. Markets tend to trade the expected path more than the current snapshot.

The other complication is that yield-seeking flows also look at the volatility of the currency. A 1.5 percent real advantage is not worth much if the pair moves 10 percent a year, which is the usual carry trade argument.

The real rate calculation shows clearly why nominal rates can mislead. Country A's 5 percent policy rate looks attractive until inflation of 6 percent is subtracted, leaving a negative real return. Country B's 3.5 percent becomes a positive 1.5 percent real return. An investor focused on purchasing power would prefer B by 2.5 points. This pattern has appeared in many emerging markets, where high nominal rates failed to prevent currency weakness because inflation was even higher. Real rates give a better sense of whether holding a currency actually rewards the investor.

When I filled in my own sheet I used AUD, JPY and CHF, with rough numbers from the time. Australia had a cash rate near 4.1 and inflation near 3.2, a real rate of about plus 0.9. Japan had a policy rate close to 0.5 against inflation near 2.8, about minus 2.3. Switzerland had 0.5 against 0.8, about minus 0.3. So the ranking was AUD, then CHF, then JPY, which matched what the long term AUD/JPY chart did over the previous year.

What I learned is that my broker's swap reflects the nominal difference between two rates, not the real one. A long on a currency with a negative real rate can still pay a positive swap, so the swap column can make a weak currency look attractive when it is not.

I use the real rate only as a tie breaker for swing trades and ignore it completely for scalps.

The forward looking version is the more useful one in practice. Current inflation is backward looking, reflecting price changes over the past year. Investors care about what inflation will do over the holding period. If Country A's inflation is expected to fall to 3 percent next year while its policy rate stays at 5, the forward looking real rate is plus 2 percent, better than Country B's. Inflation expectations can be drawn from surveys, central bank forecasts, or, where available, inflation linked bond markets. Using them often changes the ranking compared with the current figures.

Risk adjustments are important for high inflation countries. Investors often demand a premium for holding currencies with political instability, weak institutions, or high debt levels. That premium can outweigh a positive real rate. A country with a real rate of 3 percent but significant political risk might still see its currency weaken if investors fear sudden changes in policy or capital controls. So real rates are one input among several. They're most useful for comparing countries with similar risk profiles, such as major developed economies, where the risk premium differences are smaller.

Using real rates as a first filter for carry candidates, as the post concludes, is a sensible approach. A currency with a high nominal rate and a negative real rate is a poor carry candidate, since inflation erodes the return and often the currency itself. A currency with a modest nominal rate and a solid positive real rate may offer a better risk adjusted return. Has anyone here compared real rates across currencies when choosing carry trades? I'd be interested in which inflation measure you used and whether the ranking matched the currencies' actual performance.