Conceptualizing Forces Driving the Euro-Dollar Exchange Rate

We identify two main forces that have driven the euro-dollar exchange rate in recent months. The first is the divergent monetary policy trajectories, with the Federal Reserve easing policy through the end of June, while the ECB today delivered its second rate hike in the cycle that began in Q2. We expect the ECB to hike rates at least a couple of more times before the Federal Reserve raises its Fed funds target.

The second force is the European debt crisis, where the EU/IMF have failed to contain, let alone provide closure, to the crisis that began eighteen months ago.

These two forces have been reflected in one number: the two-year interest rate differential between the US and Germany. Before it became clear, at the end of last August, that the Fed was going to engage in QEII, the US 2-year note yield was about 10 bp lower than Germany's. Even after QEII began, the differential had did not move very much. At the end last year the US discount was 20 bp.

The big shift took place in both the euro and the 2-year differential starting in mid-January, when the ECB began preparing the market for rate hikes and US economic data began disappointing.

The two-year differential widened to 132 bp by early May. In fact the day that the US discount to Germany was the greatest coincided to the day that the euro peaked, May 4th. Since then, however, the spread, like the euro-dollar exchange rate, has been chopping around in a range. The trajectory of ECB policy expectations is being counteracted by the safe haven flows driven by the intensification of the European debt crisis.

While correlation and regression analysis using daily data is promising the relationship is tighter on a weekly basis. While the change seems to be more important than the level in understanding short/medium term moves in the exchange rate, the level is also worth monitoring for medium and longer terms investors. The key level of the spread now seems to be around 100 bp. The US discount has not been less than 100 bp since the end of Q1.

The US discount to Germany, though has been recording smaller extremes. After the widest spread was recorded on early May near 132 bp, the next extreme late in the month was near 131. The next extreme print was in early June near 130 and most recently, earlier this week, was about 122. It is now near 112 bp, having been to 107 in the European morning as the rout in peripheral bonds/CDS continued.

Corresponding to the large US discount to Germany on 2-year paper and the peak in the euro, the net speculative long position at IMM, a helpful gauge of short-term market position, peaked in early May, at its highest level since July 2007 (~100k contracts). The most recent reading (positions as of June 28th) shows the net speculative position at about 2/3 of its peak. Subsequent price action, and in particular the euro's 3 cent rally from June 28th to July 5th, suggests speculative players were likely rebuilding longs. However, the inability of European official to agree to way to get the private sector involved with a second aid package and the Moody's slash of Portugal's credit rating likely forced out some of the weak longs in recent days.

The European debt crisis remains far from resolved and, if anything, more poor news should be expected in the coming weeks, including other rating agencies may cut Portugal's credit rating. Does it make sense after all for a country that is on international assistance to be regarded as investment grade? While Ireland has much to recommend itself, including positive growth and a trade surplus, its debt burden is heavy and growing (not running a primary budget surplus). It is frozen out of the capital markets and it is difficult to see it returning next year on sustainable terms.

Moreover, it is not clear that European officials can contain the crisis to the three relatively small peripheral countries. The bond markets and credit default swaps reflects increased pressure in recently in Spain and Italy, for example. And the poor ISM readings warn of increased risks to growth and this can only aggravate the crisis and mitigate efforts to stabilize the important debt/GDP ratios.

Meanwhile, the US ADP data gives rise to hopes of a stronger US employment report tomorrow, even though it has not been a very reliable indicator. Even if the June non-farm payrolls data shows some improvement, because it would not spur a shift in Fed expectations, the lasting impact on the dollar may be minimal.

Lastly, indicative pricing in the options market is also often useful in the price discovery process. What we have often found to be helpful is the divergence between spot and the 25 delta risk-reversals. In late June, as the euro weakened to about $1.41 ahead of the Greek parliamentary votes, the premium the market was paying for euro puts over euro calls reached 3%, which is the largest premium since June 2010, when the first wave of the European debt crisis was reaching a mini-climax.

The euro's recovery in after the Greek parliamentary votes carried the single currency back above $1.45 but the premium for euro puts over calls did not return to any where close to where it has been the last time the euro was near $1.45 (which was in early June and when euro puts were at a 2% premium to calls). This could, arguably, reflect heightened anxiety over the outlook for the euro. Investors should consider monitoring the euro's risk reversals to compliment the analysis of spot. The current reading suggests the market less comfortable with long euro exposure than the relative resilience in the spot market would seem to imply.