In the aftermath of the 2008 global financial crisis, central banks around the world slashed short-term interest rates to unprecedented levels. The Fed Funds rate in the U.S. declined to zero percent. In Europe and Japan, short-term rates fell below that level and into negative territory. European and Japanese banks began to charge depositors for the privilege of placing their money in institutions. At the same time, quantitative easing programs resulted in central banks purchasing government, and in some cases high-quality corporate, debt securities to keep rates artificially low further out along the yield curve. To stimulate the economy and prevent the potential for recessionary pressures or worse, central banks dug deep into their monetary policy toolboxes to encourage borrowing and spending while inhibiting saving.
In 2014, after the U.S. economy began to show signs of continued moderate economic growth, the Federal Reserve first tapered the QE program and set the stage for increasing the short-term Fed Funds rate in what was a liftoff from zero percent. At their most recent June meeting, the Fed raised the short-term rate for the seventh time to 1.75% and added another hike on its agenda for 2018. By the end of this year, the rate will likely stand at the 2.25% level. Last October, the U.S. central bank began the process of removing the legacy of QE from their balance sheet by allowing debt purchases to roll off gradually. At the end of 2017, the Fed upgraded their forecast of U.S. economic growth from “moderate” to “solid.”
Meanwhile, in Europe, short-term rates remain in negative territory and will likely do so until 2019, but the ECB recently told markets that QE would come to an end at the end of this year. The European economy has been lethargic with the latest GDP growth at only 0.4%. The flood of liquidity provided by the ECB to stimulate the economy runs the risk of creating inflationary pressures if the printing press continues to run.
There are many factors when it comes to the value of one country’s currency versus other foreign exchange instruments. A shift from years of monetary policy accommodation in Europe will likely cause increased volatility in the euro currency as short-term interest rate differentials can be a significant factor in the foreign exchange market.
As the daily chart of the euro versus U.S. dollar currency relationship highlights, the value of the euro currency has slipped since highs of over $1.2740 in February of this year to lows of $1.1613 in late May. After a recovery to just under $1.20, the euro returned to very close to its lows against the dollar in mid-June.
The weakness in the euro was likely the result of the market’s disappointment that the European Central Bank has not gone far enough to tighten credit and that any move in that direction will come at a snail’s pace. By the end of 2018, the spread between U.S. dollar and euro currency short-term interest rates is likely to be at the 2.65 percent level which caused the latest move in the relationship between the two foreign exchange instruments. We are likely to see lots of volatility in the currency markets over coming weeks and months because of the widening rate gap and trade issues. Trading the euro-U.S. dollar in a volatile environment offers lots of opportunities for market participants these days.