The dollar is a reserve currency because central banks all over the world hold the greenback because of its stability over time. The euro is also a reserve currency for the same reason. The global perception of the political systems of the United States and Europe make the two currencies the leading foreign exchange instruments with the most volume and liquidity traded on a daily basis in the massive international foreign exchange arena.
Many factors determine the level of the dollar and euro, but interest rate differentials play a significant role in their respective values. A collection of currencies comprises the dollar index, and the euro represents around 57 percent of the index.
Central banks determine short-term rates while market forces are responsible for longer-term yields for the dollar and the euro. In the U.S. the Federal Reserve manages monetary policy via the Fed Funds rate while the European Central Bank determines the short-term interest rate for the euro.
In 2015, the short-term yield of the dollar stood at zero percent. In Europe, the rate was at negative forty basis points. The rates stood at historic lows because of the 2008 financial crisis. Central banks slashed interest rates to encourage borrowing and spending and inhibit saving to stimulate economies in the wake of the crisis. At 40 basis points, the spread between the two currencies was negligible. While the U.S. economy began to grow at a moderate pace, European growth remains stagnant. The Federal Reserve started tightening credit in December 2015 with the first 25 basis point hike in the Fed Funds rate.
As of the end of 2018, U.S. short-term U.S. rates have increased to 2.25-2.50 percent because of strong economic growth. In Europe, the economy remains lethargic, so rates have not moved from their lows which remain in negative territory. The dollar index had reached a peak at 103.815 in January 2017 in part because of the widening differential between the dollar and short-term euro rates. However, the anticipation of tighter credit from the ECB contributed to a correction in the dollar that took the index to a low at 88.15 in February 2018. An accelerated pace of interest rate hikes in 2018 caused the dollar to find a bottom at the start of this year, and it has been making higher lows and higher highs over the past ten months leading to its most recent peak at the 97.705 level during the week of December 10.
On December 19, the Fed hiked rates by another one-quarter of one percent, but instead of adding fuel to the rally in the dollar index, it declined in the wake of the move which is counter-intuitive.
As the weekly chart highlights, the dollar index dropped from the most recent peak to trade at under 96 on Thursday, December 27. The rate hike should have been bullish news for the dollar index, but when a market moved lower in the face of news that should take it higher, it is often a sign of underlying weakness. As we move into 2019, the dollar index did not respond to the widening differential between U.S. and European short-term rates which now stands at 2.65-2.90 percent. The lack of upside momentum in the dollar index could be a sign that 2019 will be a volatile year in the currency markets with lots of opportunity for traders.