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EUR-USD Rate Differential

Published 12/30/2014, 11:12 AM
Updated 07/09/2023, 06:31 AM

There are many things behind the decline in the euro that pushed from $1.40 in early May to fresh two-year lows yesterday. Chief among those reasons, we posit, is the diverging trajectory of monetary policy.

The Great Graphic, created on Bloomberg, shows the euro-dollar exchange rate (yellow line) and the discount Germany pays under the US to borrow 2-year money (white line). Here is Q4 the two time series appear to be moving in lockstep again after diverging somewhat in Q3.
Euro-Dollar Exchange Rate

Each side has had its own perturbations. The German 2-Year fell below zero in August and has not been in positive territory since then. It did recovery from -10 bp to almost flat in late November before falling new amid heightened speculation of a sovereign bond buying program in early 2015. It made new record lows early today near -11 bp. The limited contagion of Greek political uncertainty, and the intensification of deflationary pressure in Spain (-1.1% vs -0.7% consensus and -0.4% in November) has kept expectations of ECB bond buys elevated. Italian, Spanish and Portuguese 10-year bond yields all fell to record lows today.

The U.S. 2-Year yield 50-60 bp in late summer before being halved to 24 bp in mid-October. However, the real sector data, including various labor market measures, have continued to improve, and the forward guidance by the Fed's leadership has given investors warning of a rate hike around the middle of 2015, barring a significant data surprise. The yield reached almost 75 bp last week, the highest in three years. The pullback in the US 2-year yield (now near 67 bp) and the 7 bp narrowing in the premium over Germany may signal a near-term consolidation phase for the euro, which fits nicely into the light participation expected now until early next week.

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