A couple of months ago I wrote about the two contradicting factors at work that prevented the USD/EUR from finding direction. This has changed of late. While from a longer term perspective the movement is still relatively benign, the recent strengthening of the euro has been noticeable. From the beginning of September until now the euro has strengthened 5% against the dollar. This was not what I expected a couple of months ago. What happened?
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Factors Moving the USD/EUR Exchange Rate
Well, only one thing, really. The appreciation of the euro is a direct result of the surprise decision by the Fed to postpone the reduction in bond purchases. First, let’s take a look at the two dominant factors moving the USD/EUR again? One factor is the change in the size of the Fed’s balance sheet relative to the size of the balance sheet of the ECB. This is a measure of relative liquidity or relative supply. The central bank that blows up its balance sheet most, supplies more of its own currency, pushing the value of its currency down. The relationship between the exchange rate and the relative size of the balance sheet is shown in the graph below.
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The second factor influencing the USD/EUR exchange rate is the change in the short term interest differential between the US and Europe (Germany). Higher US interest rates make it more interesting to hold dollars and vice versa (ceteris paribus of course). The relationship between the exchange rate and the interest rate differential is shown in the next graph. Together these two factors alone explain about half of the changes in the USD/EUR exchange rate.
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The Fed Decision
The decision by the Fed not to start reducing its monthly amount of bond purchases affects both factors in a similar way that helps to explain the appreciation of the euro. First, postponing bond tapering means that the size of the Fed balance sheet keeps growing even faster relative to the balance sheet of the ECB. At least in the short term that is. Also, the expectations of investors concerning the bond taper have been altered by the unexpected Fed move. For example, Société Générale managing director and head of U.S. interest rate strategy Mary-Beth Fisher stated recently that the scenario in which the FOMC announces an increase in QE at its policy meeting this week is “not a possibility we can ignore.” The Fed is expected to blow up its balance sheet even more both in absolute as in relative terms.
The decision not to taper also influences the interest rate outlook. Although, the Fed has desperately tried to separate the bond buying measures from the (traditional) interest rate policy, tapering is unmistakably tied to (expectations about) short term rates. To underpin this relationship I have plotted the implied probabilities of several Fed Funds Target Rates (taken from the Fed Fund Futures) at the FOMC meeting held in December 2014 (the date that functions as the pivot point in the discussion when the first rate hike will be a fact).
It shows that between October 25th and my previous article the probability of at least one rate hike by the December 2014 FOMC meeting has almost halved. Back in August there was a 41% probability of a Fed rate of 0.50% or more by December 2014. Currently this is only 23%. Hence, postponing bond tapering has direct consequences for the expectations about the Fed Target Rate and short term interest rates in general. The graph above also points this out. If anything, the interest rate differential between the US and Europe has decreased.
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The Surprise Effect
The current indefinite postponement of the tapering by the Fed has significantly impacted the USD/EUR exchange rate. Both major factors moving the USD/EUR exchange rate, the size of the Fed’s balance sheet relative to that of the ECB and the interest rate differential between the US and Europe have been impacted by this decision. And, in such a way that both have been pushing the euro higher. The Fed surprised the markets and the effects of this surprise are clearly visible in the direction of the USD/EUR exchange rate.
This will probably be different in the longer term. The Fed will eventually start reducing its extraordinary measures and slowly move into a normalization of monetary policy. At the same time the ECB might have more tricks up its sleeve. Especially now that the ECB has announced its ‘comprehensive assessment’ of the European banking system. This might provoke another round of LTRO. Also, the current Eurozone inflation is 1.1%. This is not really in accordance with its famous goal of an inflation level below but close to 2.0%. This could entice the ECB to lower interest rates once more, even though that would be more of a symbolic gesture. However, in the short-term the surprise action by the Fed will probably be the sole factor keeping the dollar from appreciating.