The global financial crisis of 2008 caused central banks around the world to dig deep into their monetary policy toolboxes to come up with solutions to stimulate economies.
In the U.S. the Fed slashes short-term rates to zero using the Fed Funds instruments. The central bank also rolled out a program of quantitative easing where they bought government debt to lower rates further out on the yield curve. The policies worked, and in late 2015, the U.S. central bank began tightening credit by increasing the short-term rate by 25 basis points. The Fed has acted five more times with the latest rate hike in March 2018 lifting the Fed Funds rate to a band between 1.50-1.75%. Given the economic growth, the central bank expects to act at least twice more in 2018, and three times each in 2019 and 2020. At the same time, last October the central bank began allowing the legacy of QE to roll off their balance sheet.
Europe followed the U.S. Fed and slashed short-term rates, but they went further. The rate fell to negative forty basis points. At the same time, while the U.S. program of QE only included government debt securities, the Europeans allowed for purchases of selected private sector debt. The European economy has displayed growth, but the European Central Bank has yet to shift to tightening. In a sign that the economy on the other side of the Atlantic Ocean has responded to the stimulus provided by the ECB, the euro currency has increased in value dramatically against the U.S. dollar since the beginning of 2017.
As the chart of the euro currency versus the U.S. dollar highlights, the relationship has moved from $1.03405 in early 2016 to its current level at $1.22802, an increase of over 18.8 percent in five quarters. The appreciation in the value of the euro is significant as currency values tend to be a function of interest rate differentials. Short-term dollar rates have increased from zero to 1.5 percent, which typically would support gains in the U.S. currency at the expense of the euro. However, the opposite has occurred which could be a sign of strength for the European economy.
The tools employed by the ECB during the aftermath of the financial crisis a decade ago were successful as they provided stimulus by inhibiting saving and encouraging borrowing and spending. Therefore, it is only a matter of time before the ECB will pivot from a dovish to a hawkish orientation to monetary policy. When rates begin to rise in Europe after years in negative territory, we are likely to see an increase in volatility in currency markets as well as other markets that move with the foreign exchange markets. Volatility creates a myriad of opportunities for nimble traders who thrive during periods of increased price variance.
The Fed began its tightening course in late 2015, and the ECB is now more than two years behind the U.S. central bank. It is only a matter of time until Europe shifts, and the move will result in lots of action in currency markets.