The fluctuating relationship between the US dollar and the euro has been a subject of intense discussion among financial experts, central banking authorities, and market analysts, particularly since early 2017. Contrary to widespread expectations following President Trump’s election – which anticipated a stronger dollar due to proposed economic policies like infrastructure spending, tax reforms, and deregulation – the dollar’s value against the euro actually declined. This unexpected depreciation raises significant questions given the dollar’s crucial role in the global financial system (Boz et al. 2018).
So, what factors can explain this surprising behavior of the dollar in euro exchange rate? This article argues that shifts in interest rate spreads are the primary drivers behind these exchange rate movements. This analysis of past data offers valuable insights, especially considering previous findings highlighting the difficulty in predicting dollar-euro exchange rate fluctuations (Cheung et al. 2017).
A logical starting point to understand these currency dynamics is to examine the exchange rate in conjunction with the interest rate differentials between the US and the Eurozone.
Figure 1 US dollar–euro rate and German–US 10-year spread
Figure 1 illustrates the dollar’s initial appreciation post-Trump election in November 2017, moving from $1.10 per euro in October to $1.05 by December. This strengthening coincided with a rise in US interest rates, fueled by market anticipation of President Trump’s policies boosting economic growth and inflation. Consequently, the spread between German and US 10-year bond yields widened, from -1.76% in October to -2.24% in December, reflecting increased investor confidence in the dollar.
However, from January to September, this trend reversed. As the interest rate advantage of the US narrowed to 1.85%, the dollar depreciated 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 was facing delays and uncertainties. Secondly, the Eurozone economy experienced robust growth, and positive political developments in Europe, including elections in the Netherlands and France that saw pro-euro politicians prevail, bolstered confidence in the euro.
Interestingly, the correlation between the dollar-euro exchange rate and the German-US interest rate spread weakened from October onwards, suggesting other factors might be at play.
Beyond the core Eurozone economies, the bond yields of financially weaker nations within the Eurozone periphery can also influence the exchange rate. Concerns regarding public debt or political instability in these countries can lead to higher bond yields and potentially weaken the euro.
To investigate this further, Figure 2 examines the spread between Spanish and German bond yields as an indicator of yield trends in the Eurozone periphery (note the inverted scale for Spanish-German spread). This reveals a notable correlation. The euro’s strengthening towards the end of the period coincided with a decrease in the Spanish-German yield spread, from 130 basis points to around 85 basis points, which would typically support euro appreciation.
Figure 2 US dollar–euro rate and Spanish–German 10-year spread
To quantify these relationships, we analyzed the monthly changes in both interest rate spreads and the monthly percentage change in the dollar-euro exchange rate. The analysis revealed a strong positive correlation of 0.79 between changes in the German-US spread and changes in the exchange rate, indicating a significant relationship. Conversely, the correlation between changes in the Spanish-German spread and the exchange rate was -0.53, also statistically significant, suggesting an inverse relationship.
Subsequently, a regression analysis was performed, examining the impact of changes in the German-US and Spanish-German interest rate spreads on the dollar-euro exchange rate. These two interest rate spreads together explained a substantial 78% of the exchange rate’s fluctuation. The results showed that a 10 basis point increase in German yields relative to US yields led to a 1.1% appreciation of the euro (t = 8.5), challenging the uncovered interest parity theory. Similarly, a 10 basis point decrease in Spanish yields relative to German yields resulted in a 0.6% euro appreciation (t = 4.1).
Figure 3 visually breaks down the monthly changes in the dollar-euro exchange rate into components attributed to changes in the German-US yield spread and the Spanish-German yield spread. The German-US spread changes appear to be the dominant factor driving exchange rate movements from late 2016 to October 2017. The Spanish-German yield spread variations also played a significant role, particularly in early 2018.
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
This analysis suggests that the dollar’s depreciation against the euro in 2017 was largely driven by rising German long-term bond yields relative to US yields and falling Spanish yields (representing the Eurozone periphery) relative to German yields. While the sample size is limited to 17 data points, the strong correlations and statistical significance offer compelling evidence.
To assess the broader applicability of this model, it was re-estimated using data extending back to the euro’s inception. This expanded analysis, incorporating a lagged dependent variable to account for dynamic effects, confirmed the robustness of the findings. Despite a decrease in explanatory power to 22% with 228 observations, the estimated impacts of the German-US and Spanish-German spreads remained highly significant. Importantly, tests for structural breaks indicated no significant parameter instability over time.
In conclusion, this analysis highlights that a significant portion of the dollar-euro exchange rate fluctuations observed since President Trump’s election can be attributed to shifts in the relative attractiveness of holding US dollars versus euros, as reflected in interest rate differentials. Understanding these dynamics is crucial for investors, policymakers, and anyone tracking the ever-evolving landscape of international finance.
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.
Endnotes
[1] See Rossi (2013) and Marcelliono and Abbate (2017) for discussion of difficulties forecasting exchange rates out-of-sample.
[2] The constant in the regression (0.92) has been subtracted from the change in the exchange rate.
[3] The parameter is 0.27 (t = 5.25).
