The Euro and US interest rate differential: an imbalance?
ECB refinance rate (Source: Bloomberg)
The recent dollar plunge as a result of falling US interest rates may be short lived. Last week the U.S. Federal Reserve cut its target rate to a band of 0-0.25% while the ECB overnight rate remained at 2.50%. Their statement included several indications of their willingness to continue quantitative easing, possibly foreshadowing a Japan-like decade. See the following excerpts from the FOMC statement:
“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.”
“As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.”
ECB refinance rate (Source: Bloomberg)
The fact that the fed is officially stating their intention to buy more junk from its country is not good news for the United States economy, but more importantly, the world. A theme that I will repeatedly incorporate into this blog is that the Fed sets the price of money and the rest of the world follows, even though they have their own central banks. Those who believe in the decoupling story (that the world no longer depends on the US economy because of growth in China, India, and other emerging markets) may try to disagree with me but we still see the rest of the world following America’s economic downturn, and decoupling is not something that happens over a short time period.
The Euro has rallied against the dollar over the last couple of weeks because market participants have turned their attention to how bad the fundamentals in the US are, and furthermore that the interest rate differential widened (US rates lower). The safe haven flow into the US thus reversed and we saw a move in the Euro from sub-1.3 to 1.45 before settling at 1.4 as of this writing.
EUR/USD daily exchange rate (Source: Saxobank)
Reasons abound for being long the dollar and the Euro exchange rate looks really out of line right now. Here are some arguments:
1. The market has been rewarding the Euro due to the ECB’s stubbornness against lowering interest rates. However, inflationary pressures are gone and Europe and the rest of the exporting world need to support growth. Thus the ECB will follow the US’s lead and continue to lower interest rates. Although one shouldn’t expect rates to go near zero in the Eurozone, rates should go low enough to reduce demand for Euros and bring the exchange rate down to less lofty levels.
2. Although implied volatility has dropped from extreme levels, it is still high and liquidity is king in such situations. The US dollar and US treasuries are the most liquid assets in the currency and bond classes, respectively, so they should be well bid.
3. The People’s Bank of China has already started dropping rates to attempt to maintain growth at 8% and this has been the fifth cut in three months.
3 Responses “The Euro and US interest rate differential: an imbalance?”
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