The currency markets are trading on perceptions and expectations of interest rate changes, and this has driven values since the beginning of the year. The main point is that the US central bank is sticking to its current liberal monetary policy that targets job growth, and in speeches saying higher equity prices are beneficial.

Since January 1st, the Federal Reserve has got close to what it has desired with the S&P 500 increasing nearly 6% and the US unemployment rate falling from November’s 9.8% to February’s low of 8.9%. Yet, the testimony this week by Federal Reserve chairman Ben Bernanke indicates that the current policy will remain in place despite the improvement and despite the inflation risks. This means that the Fed is anchoring expectations of policy until June when the second round of quantitative easing or QE2 finishes.

The rest of the world is not so complacent or sanguine when it comes to inflation risks.

Andrew Busch
Dir., Global Currency & Public Policy Strategist
BMO Financial Group

This means that countries like Brazil, United Kingdom and the Euro zone are seeing their currencies rise in value against the US dollar. It also means that a country like New Zealand is seeing their currency weaken as they indicate a track to lower interest rates.

While the Bank of England left interest rates unchanged at 0.5% on February 23rd, the vote was 6-3 and several members indicated that they want to raise rates to address the rapid rise in inflation. Core inflation is running at 3.0% and they will next meet on March 10th to decide on rates.

On March 2nd, Brazil raised their overnight interest rates (Selic) 50 basis points to 11.75%. They indicated that they will do more to combat inflation (CPI 9.7%) in their robust economy with the market looking for another 50 basis points of rate hikes before the end of the year.

Finally, the ECB met this week and left interest rates unchanged at 1.0%. However, ECB President Claude Trichet stated that an April rate increase is possible despite the lackluster growth for the European Union and despite the sovereign debt problems of Greece, Ireland and Portugal.

From the first week in January, we have seen the British pound appreciate 4.5%, Brazilian real appreciate 2.75% and the Euro appreciate 6.0%% against the US dollar. It is also why the New Zealand dollar has fallen 2.5% at the same time. It is these interest rate expectations and actions that are currently driving values and remain the force behind the big moves.

For the US dollar to reverse its downward slide, an increase in US rate expectations will have to happen without other nations indicating that they will raise rates as well. Until the Federal Reserve ends their QE2 or indicates they will raise rates sooner than currently expected, these forces will remain in play.

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Andrew B. Busch Director, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a contributor to CNBC's Money in Motion Currency Trading.

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