Magazine article Modern Trader

The Euro and the Logic of Money: Careful Analysis of Where the Dollar/euro Has Been May Give Us Some Clues to Where It Might Go

Magazine article Modern Trader

The Euro and the Logic of Money: Careful Analysis of Where the Dollar/euro Has Been May Give Us Some Clues to Where It Might Go

Article excerpt

It has been 15 years since the fall of the Berlin Wall and the collapse of communism in Eastern Europe. One memorable image of that era was the reopening of a bridge between Romania and the largely ethnically Romanian Soviet Republic of Moldova. Crowds were poised on either side of the bridge, and for one tense moment no one could bet against a mutual attempt to flee to the other side.

Some aspects of global currency trading have a similar feel, especially in the largest bilateral market of all, the dollar/euro cross. The euro spent its first three years on the run, only to be replaced by the greenback as an object of scorn and derision.


What prompts such powerful and enduring trends? One set of simple answers seized on by those who like to view economics as some sort of morality play, lies either with something dubbed "Eurosclerosis" or with American economic excesses. The shorthand for the latter has been subsumed in the phrase "twin deficits," in honor of our persistent merchandise trade and federal budget red ink. But financial markets are not futures contracts on macroeconomic variables (see "It's not the economy, stupid," March 2004). The attribution of dollar strength or weakness to either deficit is a nice theory, but it is totally bereft of any sort of empirical evidence on its behalf (see "Twin deficits pass the buck," above).

Currency trading actually is far less dramatic. It is simply borrowing in the country whose currency you are selling and lending in the country whose currency you are buying. These two interest rates are of necessity nominal rates, which include both a real rate of interest and an expected rate of inflation. The two real rates must be identical at identical maturities and at identical credit risk to preclude arbitrage.

The spot exchange rate both closes this interest rate relationship and reflects the market's expectations for relative asset returns. Other factors can enter the equation as well, and not just the obvious ones of political interference and country credit risk. The Japanese yen, for example, could rise through periods of both near 0% nominal interest rates and poor asset returns because importers eventually had to buy yen to pay their Japanese exporters.


The euro could pull a V-shape reversal because the underlying short-term rates pulled a V-shaped reversal in late 2002. Over the entire money market horizon, U.S. rates exceeded their European counterparts until the Federal Reserve already had cut interest rates by 200 basis points. This rate cutting led many investors to believe in an impending economic rebound and therefore greater returns on dollar-denominated assets. By 2002, hope ceased to spring eternal and the euro's rebound began.

The Fed's enthusiasm for rate cuts into 2003 produced the opposite effect; the yawing rate gap raised the specter of higher American inflation, and the euro strengthened accordingly. Even though the gap began to close by late 2003, it was not until the release of March 2004 employment data that investors began to take the prospects of American interest rate increases seriously (see "Persistent gaps," above). The gap closed fastest at the nine-month and one-year horizons; by the end of September 2004, U.S. rates exceeded European rates even as the perception of U.S. monetary excess persisted.

The longer-term notes tell a similar story (see "Out of line," above). The rate gap at five and 10 years never got as extreme as the two-year notes' gap as the market discounted the Fed's policy as short-lived. By the fourth quarter of 2004, a time when the dollar sank steadily against the euro, the yield advantage at the note horizon favored the dollar quite strongly.

These note yields are nominal. Ideally, we would compare inflation-protected notes, but there are no euro-denominated equivalents to our TIPS. And, it is important to keep in mind that simply adding the CPI to the TIPS yield will create something quite different from the nominal note yield (see "Can the CPI catch your eye? …

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