EUR/USD exchange rate and its relationship with the Fed’s and ECB’s monetary policies

05.05.2023 14:22|Investment Advice Department, Conotoxia Ltd.

Interest rate decisions by the Federal Reserve and the European Central Bank were among the most awaited events on the economic calendar this week, having a strong impact on the financial markets, including government and corporate debt instruments, companies’ shares, as well as national currencies. Meanwhile, in this article we will discuss these events from a broader perspective. In particular, the relationship between the interest rates in the US and eurozone – historically and potentially, in the near future, as well as, how this relationship may impact the world’s most traded exchange pair EUR/USD.

Summary

  • Higher interest rates generally have a bullish effect on the national currency. 
  • Both - the US and the eurozone - started raising interest rates last year. Due to differences in the state of both economies, the Fed started raising interest rates earlier than the ECB.
  • The current expectations of peak interest rates are 5.1% in the US and 3.55% in the eurozone. 
  • Historically, the ECB marginal lending rates tend to peak close to the same level as US interest rates and stay high for longer.
  • Historical movements of the EUR/USD rate in combination with the US and eurozone interest rates have followed the axiom that higher interest rates boost the national currency’s value.
  • EUR/USD rate may appreciate further as long as the ECB is not cutting the interest rates. History tells us that the ECB interest rate cuts may be more temperate in comparison to the Fed suggesting that even then the EUR/USD rate may reflect not a depreciation. 

Repetition – the mother of knowledge 

While the relationship between a country's interest rates and its currency is complex and multifaceted, generally, higher interest rates tend to make a country's currency more attractive to foreign investors, which may increase the demand for that currency and cause its value to appreciate. Conversely, lower interest rates may make a currency less attractive leading to a decrease in demand and a depreciation of the currency.

One of the reasons why higher interest rates may make a currency more attractive is that they increase the return on investments denominated in that currency. For example, if a foreign investor can earn a higher rate of interest on a deposit in a country with higher interest rates than in their own country, they may choose to invest in that country's currency. This would lead to an increased demand for the currency with a higher interest rate causing its value to rise and lower demand for the currency with a lower interest rate causing its value to drop.

Source: IG.com

It is important to point out that the above discussion applies solely to the national currency. Meaning, when evaluating a currency pair, such as the EUR/USD, an investor needs to consider the interest rate decisions of both countries (or in this case, one country and one common currency union) and their potential relationship. 

Before moving further, it needs to be acknowledged that we have reviewed only one factor potentially having an impact on the national currency. Other important factors to mention include political stability, trade policies, market sentiment, and various economic indicators, such as GDP growth, inflation, employment rates, and trade balance. 

Current Federal Reserve and European Central Bank’s monetary policies

The year 2022 marked a change in central banks’ monetary policies around the world. In an effort to combat persistently high inflation that emerged in 2021, both – the Fed and the ECB – have been gradually increasing the short-term interest rates. While the Fed’s first decision to increase the short-term target federal funds rate came in the March 2022 meeting, ECB refrained from raising interest rates until July 2022. 

This divergence may be explained by a couple of factors. Firstly, the US went into the Covid-19 pandemic with a stronger economy – its unemployment rates were already record-low and economic growth was higher than in the EU. Furthermore, once the pandemic emerged, the nature of government support spending also diverged. While eurozone countries mostly provided loan guarantees and short-term allowances to employers for keeping their employees, the US government provided more direct financial aid to individuals via stimulus cheques and unemployment benefits. 

The US government’s actions caused two concerns – both contributing to higher inflation in the near future. Inexistent stimulus to US businesses to keep their employees on the payroll resulted in a surge in unemployment during the peak of the pandemic and a strong rise in wages upon the reopening of the economy as all the previously closed sectors struggled to attract staff back to work. According to OECD data, wage growth in Q4 2021 was 6.4% in the US while only 1.3% in the eurozone. Furthermore, generous financial aid in various forms to individuals resulted in an increased average disposable income in the US during the pandemic. This led to heightened spending on durable goods and increased pressure on global supply chains. By the end of 2021, the spending on durable goods in the US was already 20% higher than before Covid-19. On the contrary, the household savings rate, which increased during the pandemic as spending opportunities were limited, returned to normal level soon after the economy reopened in the US while it stayed elevated in the eurozone. As a result of increased demand and wage levels, the US faced faster and higher core inflation levels in comparison to the eurozone. 

Meanwhile, the eurozone faced downgraded growth prospects and supply-related inflation due to higher food and energy prices (rather than increased demand) as a result of the war in Ukraine. Furthermore, many eurozone countries, such as Italy, Greece, and Spain had not fully recovered from the pandemic-induced growth in debt-to-GDP ratios and therefore may have been exposed to a sovereign debt crisis in case of tighter monetary policy. As soon as the ECB announced the end of QE and its plans to increase interest rates, the Italian – German 10-year government bond spread grew considerably and reached a 245 bp level in September 2022. As a result, the ECB faced the difficult task of finding the equilibrium between supporting its more “peripheral” countries and tackling inflation. 

This week, both central banks have made their most recent decisions regarding interest rates. The Federal Open Market Committee (FOMC) raised the short-term target federal funds rate to a range of 5.00% to 5.25% while the ECB decided to raise the key interest rate to a 3.75% level. This marks a significant shift from the near-0% interest rate level that the Fed had maintained for two years and ECB – for over 6 years.

Source: investing.com, graph: Author

What’s next?

The Fed has indicated that the current cycle of rate increases may be coming to an end. The current projected interest rate by the end of this year in the US stands at 5.1% according to the Fed’s dot plot of the 18 policymakers. Considering that the current interest rate range has already reached the projected interest rate, in addition to the financial difficulties that seem not to leave the US banking sector, the FOMC might be extremely cautious to decide on any further interest rate hike. 

Meanwhile, the majority of respondents to the ECB Survey of Professional Forecasters expect to see the key interest rates in the eurozone to reach 3.55% in the fourth quarter of 2023, while 30% of respondents expected the key interest rate to peak at a higher level – at 4% or more. 

Now, if we put both interest rate graphs together, we may notice that historically, the Fed has been quicker to change interest rates (in both directions). Meanwhile, the ECB tends to follow the Fed’s monetary policy after some time with the exception of the Fed’s interest rate hikes during the period between 2016 and 2020. Other important tendencies that should be pointed out are that eurozone interest rates tend to peak close to the same level as US interest rates and stay high for longer. 

Although unrelated to the topic, it is interesting to mention that the below graph also shows that a recession (the shaded lines in the graph) in the US has followed every tightening cycle of the Federal Reserve. Due to timing differences, US interest rates start to fall before the beginning of a recession, while eurozone interest rates start to fall only after a recession in the US has started. Below graph serves as a good example of how influential and contagious macroeconomic events taking place in the US may be globally.

Source: Fred

The historical relationship between the EUR/USD rate and interest rates in the US and eurozone

We may use the above graph and insert another line – the number of US Dollars needed to pay for one euro (EUR/USD). As discussed above, interest rates are among the key factors influencing both currencies as well as their interaction with one another – higher interest rates lead to a stronger currency. 

We may apply this knowledge to evaluate whether the EUR/USD rate fluctuates accordingly. During the whole year 2000, US interest rates were higher than those of the eurozone, leading to an appreciation of the US Dollar (and depreciation of the EUR/USD rate accordingly). As soon as the US interest rates plunged in the year 2001 and eurozone interest rates exceeded those of the US, EUR/USD rate increased, meaning that the euro appreciated in value. Appreciation of the EUR/USD exchange rate continued until mid-2008 when ECB started cutting interest rates. 

It is interesting to notice that during the aforementioned time period, there was a slight change in EUR/USD trend during 2005. The US Dollar started to appreciate when the US interest rates started to approach those of the eurozone, which remained unchained at that point. The trend was reversed as soon as the ECB announced its first interest rate hike in December 2005.  

After the EUR/USD had reached its record high level of 1.60 in mid-2008, it retraced back to a lower level, but higher eurozone interest rates kept the EUR/USD exchange rate in the brackets of 1.25 and 1.50 until mid-2014. For a comparison – from 2015 until mid-2022 when the ECB marginal lending rate was near zero, the EUR/USD fluctuated around 1.125 and even reached parity when the Fed elected to start raising interest rates.

Source: Fred

We may conclude that the historical movements of the EUR/USD rate in combination with the US and eurozone interest rates have followed the axiom that higher interest rates boost the national currency’s value.

What may be expected from the EUR/USD in the near future?

Combining the current central bank stances as discussed above with the historical data, we may approximate that both – the US and eurozone – are around the same level in terms of interest rates as in the mid-2000 and mid-2006. This denotes that the Fed may be done raising interest rates and a sharp decline in interest rates may be expected within the following 12 months. Meanwhile, the ECB may continue raising interest rates according to its plan and may start a slower decline in interest rates once the recession is officially started in the US. 

EUR/USD rate may appreciate further as long as the ECB is not cutting the interest rates. History tells us that the ECB interest rate cuts may be more temperate in comparison to the Fed suggesting that even then the EUR/USD rate may reflect not a depreciation. 

As a conclusion, it is crucial to point out two important factors. First, while it may be beneficial to know history, there is no guarantee that history will repeat itself. And second, there are numerous other factors that may influence the EUR/USD rate in the future, and it is important to gain a comprehensive opinion about their combined impact on the exchange rate movements. The recent and ongoing shrinkage of the US Dollar’s influence in the world as the reserve currency and oil currency may serve as a good example for both these factors. 

 

Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)

Materials, analysis, and opinions contained, referenced, or provided herein are intended solely for informational and educational purposes. The personal opinion of the author does not represent and should not be constructed as a statement, or investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73,18% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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Santa Zvaigzne-Sproģe, CFA

Santa Zvaigzne-Sproģe, CFA

Head of Investment Advice Department

A certified financial analyst with a broad experience in financial markets obtained working as a broker and securities specialist in various financial institutions across the Baltics.

In addition to obtaining the prestigious CFA license from CFA Institute and Advanced Certificate from CySEC in 2022 as well as Investment Advisor’s license from Baltic Financial Advisor’s Association in 2019, Santa holds MBA from Swiss Business School in Switzerland and master’s degree in finance from BA School of Business and Finance in Latvia.


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76.23% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76.23% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Trading on CFDs is provided by Conotoxia Ltd. (CySEC no.336/17), which has the right to use the Conotoxia trademark.