The question “How Much Is A Euro In Dollar?” is a frequent one for individuals, businesses, and financial institutions alike. Understanding the fluctuations in the euro to US dollar (EUR/USD) exchange rate is crucial in today’s interconnected global economy. While many factors can influence currency values, a closer look at recent trends reveals a compelling story driven by interest rate dynamics. Particularly since early 2017, the weakening of the US dollar against the euro presented a puzzle, challenging initial expectations and prompting deeper analysis into the mechanics of this vital exchange rate.
Following the 2016 US presidential election, conventional wisdom suggested that the dollar would strengthen. The anticipated economic policies of the new administration, focusing on infrastructure spending, tax cuts, and deregulation, were expected to stimulate economic growth and inflation, typically leading to a stronger currency. However, the opposite occurred. The dollar depreciated against the euro, causing concern given the dollar’s central role in international finance. This unexpected behavior necessitates an examination of the underlying factors at play in the dollar-euro exchange rate.
A key to understanding these movements lies in analyzing interest rate differentials between the United States and the Eurozone. It’s natural to consider how the relative attractiveness of holding assets in different currencies, influenced by interest rates, impacts exchange rates.
Figure 1 US dollar–euro rate and German–US 10-year spread
Figure 1 illustrates the relationship between the US dollar to euro exchange rate and the spread between German and US 10-year government bond yields. Post-Trump’s election in November 2016, the dollar initially strengthened. It moved from $1.10 per euro in October to $1.05 in December. This appreciation coincided with a rise in US interest rates, as markets anticipated the inflationary effects of the new administration’s policies. Consequently, the spread between German and US 10-year yields decreased, moving from -1.76% in October to -2.24% in December, reflecting a higher relative yield in the US, which typically strengthens the dollar.
However, from January to September 2017, this trend reversed. The interest rate differential favoring the US narrowed to 1.85%, and the dollar weakened to $1.19 per euro. Several factors contributed to this shift. Firstly, it became increasingly apparent that the implementation of President Trump’s economic agenda would be slower and less impactful than initially anticipated. Secondly, the Eurozone economy experienced a period of robust growth, and political sentiment towards the euro improved significantly following key European elections in the Netherlands and France. These positive developments in the Eurozone made euro-denominated assets more attractive.
Despite this observable correlation for much of the period, the relationship between the exchange rate and the German-US interest rate spread seemed to break down from October 2017 onwards. This suggests that focusing solely on the core Eurozone interest rates might not provide the complete picture.
The financial health of peripheral Eurozone nations also plays a crucial role in the euro’s overall value. Concerns about sovereign debt or political instability in countries like Spain can lead to increased bond yields in these nations and potentially depreciate the euro. Therefore, examining the spread in bond yields within the Eurozone itself becomes relevant.
Figure 2 US dollar–euro rate and Spanish–German 10-year spread
Figure 2 explores the spread between Spanish and German 10-year bond yields (inverted scale) alongside the EUR/USD exchange rate. The data reveals a degree of correlation. Notably, the euro’s strengthening towards the end of the sample period coincided with a decrease in the Spanish-German yield spread, falling from 130 basis points to around 85 basis points. This narrowing spread, indicating reduced risk perception within the Eurozone periphery, would be expected to support a stronger euro.
To quantify these relationships, a regression analysis was conducted using monthly changes in interest rate spreads and the monthly percentage change in the EUR/USD exchange rate. The results are compelling. The correlation between changes in the German-US spread and the exchange rate change is a significant 0.79. Similarly, the correlation between changes in the Spanish-German spread and the exchange rate change is also significant at -0.53.
Furthermore, when regressing the exchange rate change on both interest rate spread changes, these two factors explain a substantial 78% of the exchange rate variation. The effects are statistically significant and economically meaningful. A 10 basis point increase in German yields relative to US yields is associated with a 1.1% appreciation of the euro. Conversely, a 10 basis point decrease in Spanish yields relative to German yields leads to a 0.6% euro appreciation. These findings challenge the simple uncovered interest parity theory, suggesting more complex dynamics are at play.
Figure 3 Monthly changes in the US dollar–euro rate and the parts due to changes in the German–US and Spanish–German 10-year spreads
Figure 3 visually decomposes the monthly changes in the EUR/USD exchange rate into components attributable to changes in the German-US and Spanish-German yield spreads. The German-US spread appears to be the dominant driver of the exchange rate fluctuations from late 2016 to October 2017. The Spanish-German yield spread also exhibits significant influence, particularly in early 2018.
While this analysis is based on a limited dataset of 17 months, further investigation using longer-term data since the euro’s inception reinforces these conclusions. While the explanatory power of the model decreases with a much larger dataset, the interest rate spreads remain statistically significant drivers of the EUR/USD exchange rate.
In conclusion, understanding “how much a euro is in dollar” at any given time requires considering the complex interplay of economic factors. This analysis highlights that fluctuations in the euro to dollar exchange rate, particularly the dollar’s depreciation in 2017, can be largely attributed to shifts in the relative attractiveness of holding euros versus dollars, driven by changes in long-term interest rate spreads – both between the core Eurozone and the US, and within the Eurozone itself. These interest rate dynamics provide a crucial lens for interpreting the often-puzzling movements in the EUR/USD exchange rate.
References
Boz, E, G Gopinath and M Plagborg-Moller (2018) “Global Trade and the dollar,” VoxEU.org, February 11.
Cheung, Y-W, M Chinn, A Garcia Pascual and Y Zhang (2017), “Exchange rate prediction redux,” VoxEU.org, February 11.
Marcellino, M and A Abbate (2017), “Reducing the uncertainty around exchange rate forecasts: A new model,” VoxEU.org, February 4.
Rossi, B (2013), “Are exchange rates predictable?” VoxEU.org, November 14.
