The EUR/USD 2-year yield differential has been a driving factor in the decline of the currency pair. At current levels of 126 basis points between U.S. and German rates, the differential is now the widest seen between Germany and the U.S. in the past 5-years. The 2-year yields differential is a driving factor in the direction of the currency pair because it is directly incorporated into the forward rate used to trade this currency pair.
For example, if you are interested in buying the euro and selling the U.S. dollar and your settlement date is 2-years from today, you would pay away approximately 126 basis points (1.26%) for that privilege. To calculate these forward points, a market maker would convert the yield differential into forward points and subtract the difference from the spot rate. This would mean that you would be paying a rate that is above the current spot rate to settle your EUR/USD 2-years from today.
The large 2-year interest rate differential generates a negative incentive toward purchasing euros versus the greenback. In fact, you would be incented to purchase the dollar as you would earn 126 basis points if you held the currency pair for 2-years and the spot rate did not move at all. The carry (the ability to hold the position and earn income), provides a strong backdrop for an increasing dollar over the euro.
On Wednesday the FOMC released its minutes from its October monetary policy meeting. The minutes point to the beginning of the normalization process in December. While the Fed would likely hold off on increasing interest rates given current conditions if rates were not at emergency levels (zero to 25 basis points), they seem to feel compelled to move forward despite subdued inflation expectations. The jobs data has provided the backdrop for the Fed to move forward, but jobs data is a lagging indicator and inflation has not met the requisite criteria.
The EUR/USD has not yet broken through the March lows at 1.0480, but with the 2-year yield differential hitting multi-year lows it is only a matter of time before either the currency pair catches up or the yield differential retraces.