Has the euro depreciation commenced?

For some years now, a big part of the movement of the euro against the US dollar is explained by two factors; the ratio of the size of the balance sheet of the Fed and the size of the balance sheet of the ECB, and the difference between short-term interest rates. The reason for the explanatory power of the two factors is pretty straightforward. If the Fed’s balance sheet grows faster than that of the ECB, more dollars are ‘created’ than euro’s driving the value of the dollar down, and vice versa. Also, if the short-term interest rate in the US goes up relative to the short-term interest rate in the Eurozone, holding dollars becomes more attractive, and the value of the dollar goes up, and vice versa.

Vertical slope

For quite some time the combined effect of the two factors were in favor of the euro. As can be derived from the graph below, the Fed has expanded its balance sheets by a much greater extent than the ECB. In fact while the Fed, only recently, started trimming the amount of bond purchases, growing its balance sheet less aggressively, the balance sheet of the ECB actually shrank as a result of European banks paying back their LTRO loans they took in 2011 and 2012. Since the beginning of 2013 this has resulted in an almost vertical slope of the size of the balance sheet of the Fed relative to that of the ECB.

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The massive increase in the Fed balance sheet compared to the size of the balance sheet of the ECB has been the main beneficiary for the euro, pushing it up from 1.31 at the start of 2013 to almost 1.40 in May 2014. At the same time the graph also shows that the magnitude of the rise of the euro is pretty muted compared to what you might expect based on the steep slope of the black line, representing the ratio of the balance sheets of the Fed and the ECB.

This has, of course, to do with the other major factor at work here, the difference between the short-term interest rate in the US and in the Eurozone. The graph below shows that, except for the last couple of weeks, there has been a status quo in the yield difference for almost two years. On both sides of the Atlantic, short-term yields are incredible low. This status quo prevented the euro from strengthening further.

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The end of the status quo

Ok, back to the future. As mentioned above, and also clearly visible in the second chart, the status quo in the interest rates in the US and the Eurozone was broken. The Fed has scripted an exit from its quantitative easing program which will, in the end, result a rate hike. On the back of stronger macro data, the market is now starting to anticipate higher US interest rates. At the same time the ECB has stepped up its easing efforts, by lowering interest rates and by the announcement of targeted LTRO’s. It also ‘investigates’ direct quantitative easing measures, hence bond purchases. This has led to even lower interest rates in the Eurozone; the German 2-year bond yield is now practically zero. The two central banks are now moving in opposite directions, leading to a bigger gap between the short-term interest rate in the US and the Eurozone. And as the second graph suggests, a bigger yield gap would push the euro down.

Now let’s go back to the first graph one more time. While it does not show any change in the relentless rise of the size of the Fed balance sheet against that of the ECB, yet, this could very well occur in the near future. The most recent Fed minutes show that, if everything goes according to plan, the Fed will end its bond buying program in October. Around the same time, the ECB will conduct two targeted LTRO’s (September and December) for a total amount of EUR 400 billion. These will show up in the ECB’s balance sheet, affecting the ratio of the two balance sheets. And, if the ECB were to start an outright bond buying program, the relative size of the balance sheets would, of course, be impacted even more, probably causing the black line to reverse.

It seems probable that the gap between the short-term interest rate in the US and in the Eurozone will increase, given the divergence in monetary policy of the Fed and the ECB. Also, with the end of the Fed’s quantitative easing in sight, the steep rise of the size of the Fed balance sheet relative to the size of the ECB balance sheet will come to an end. This implies that the two factors that have been driving the euro dollar exchange rate will join forces again driving the value of the euro down.

One response to “Has the euro depreciation commenced?

  1. Pingback: The Week End Blog – Holy Spirits, Market Turmoil and NAIRU | Jeroen Blokland Financial Markets Blog·

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