A Template for Understanding Big Debt Crises

by Ray Dalio

There is a critical relationship between a) the interest rate difference and b) the spot/forward currency relationship. The amount the currency is expected to decline is priced into how much less the forward price is below the spot price. For example, if the market expects the currency to fall by 5 percent over a year, it will need that currency to yield a 5 percent higher interest rate. The math is even starker when depreciation is expected over short periods of time. If the market expects a 5 percent depreciation over a month, than it will need that currency to yield a 5 percent higher interest rate over that month—and a 5 percent monthly interest is equivalent to an annual interest rate of about 80 percent10 —a level that’s likely to produce a very severe economic contraction in an already weak economy. Because a small expected currency depreciation (say 5 to 10 percent in a year) would equal a large interest rate premium (5 to 10 percent per year higher), this path is intolerable.