Total Posts:2|Showing Posts:1-2
Jump to topic:

EUR/USD Question

PeachTreeLLC
Posts: 1
Add as Friend
Challenge to a Debate
Send a Message
3/11/2016 5:07:51 PM
Posted: 9 months ago
I just had a quick question regarding the EUR/USD exchange rate. Considering the recent announcement that the EU's stimulus package will be expanded, wouldn't we expect to see this exchange rate weaken and the USD grow stronger against the Euro? Does the large difference in inflation between both countries offset the idea that the interest rate difference will increase in the future?
ResponsiblyIrresponsible
Posts: 12,398
Add as Friend
Challenge to a Debate
Send a Message
3/11/2016 6:23:31 PM
Posted: 9 months ago
At 3/11/2016 5:07:51 PM, PeachTreeLLC wrote:
I just had a quick question regarding the EUR/USD exchange rate. Considering the recent announcement that the EU's stimulus package will be expanded, wouldn't we expect to see this exchange rate weaken and the USD grow stronger against the Euro? Does the large difference in inflation between both countries offset the idea that the interest rate difference will increase in the future?

Yes and no. You have the right idea, but it's a bit more complicated than that.

So the value of the exchange rate is obviously predicated on the market-implied expectation of current and future policy divergence. For instance, monetary easing all else equal SHOULD depreciate the currency, but the market reaction need not take place immediately following the policy change (and easier money should simultaneously depreciate the currency, push down longer-term interest rates (though that's a bit more contentious), and raise stock prices).

So let's say that the ECB is expected to ease, as they were both in December and at their recent meeting. Markets preemptively priced in the impacts of the expected easing -- let's say they expected an expansion of monthly asset purchases to X, a cut in the deposit rate of Y percent, and an expansion of the TLTRO's to Z.

This expectation was already embedded in market prices even before the ECB met. Let's say, then, that the ECB delivers precisely what markets expected -- in other words, in a world where markets didn't preemptively reprice assets, and holding all else constant, we would expect precisely the same market reaction. Asset prices should hold constant because the policy action was fully anticipated.

Let's take a different scenario: say that the ECB "undelivered" (which was especially the case in December, and more likely than not the case yesterday with the exchange rate holding steady): in effect, it has "tightened" monetary policy. Monetary policy is transmitted to the real economy largely through the expectations of market actors, and if markets price in a larger-than-delivered stimulus, they've temporarily eased monetary policy to a larger extent than the central bank was willing to deliver. Therefore, the reaction will be unwinding and repricing the stimulus that didn't happen, and obviously that's a bit hard to readily quantify since we don't normally say, "Okay, if stocks adjust to X price, that factors in a 10 basis-point cut in the deposit rate, whereas price Y factors in a 20-basis-point cut," but in reality that's what's happening.

In December, the exchange rate APPRECIATED -- which I predicted, by the way -- because the ECB delivered a much more timid policy than markets expected. Indeed, the "concrete step" was relatively easier than any physical concrete moves at the last meeting when the deposit rate was higher (and they did a few things in December, if I recall correctly, such as expanding the duration of asset purchases, expanding purchases into muni bonds, etc., but not nearly as drastic as expanding monthly purchases as they just did), but monetary policy on balance was tighter, because markets interpreted Mario Draghi's comments as indicative of a willingness to ease policy to a greater extent. In that sense, then, the "concrete" steps are surprisingly unimportant relative to the market perceptions of the evolution of the central bank's reaction function (i.e., how markets anticipated the central bank will adjust policy in response to the evolution of economic data, which is why we see asset prices move around follow data releases).

But to get back to the question you actually asked: if taken in isolation, if the ECB were to conduct an UNANTICIPATED policy easing, then, yes, the USD would strengthen and the euro would fall. In reality, that policy divergence has been priced in for years, so we'd be much better off discounting that "all else equal" assumption unless we were just varying anticipated moves of the Fed, most of which have been priced in, in the form of tightening. Let's say, for instance, that the ECB and the Fed were to ease unexpectedly. The first move should push the euro down and the dollar up, and the second should push the dollar down and the euro up.

(This sounds "beggar-thy-neighbor," but people who make that argument really don't know what they're talking about. It's the worst form of reasoning from a price change, but I digress.)

I'd make the case that the second move would radically overshadow the first because tightening on the part of the Fed has already been extensively, for a fairly long time, reflected in market prices.

As for differentials in inflation rates: sure, that's possible. Obviously you would tend to see a country with a lower inflation rate see its currency appreciate, all else equal, though the caveat is shifts in policy: if, for instance, the ECB were perceived (credibly) as having a reaction function that strictly prohibits materially below-target inflation, markets would price in further policy action and, ideally, inflation would be expected to rise. I think expected inflation and, more particularly, expected policy divergence and the anticipated effect on inflation matters far more than the current inflation rate, which is why most of the international finance models dealing with movements in exchange rates are far too simplistic, or assume some sort of "long run" condition with monetary neutrality, or something.
~ResponsiblyIrresponsible

DDO's Economics Messiah