The question, “What Is The Euro To The Dollar?”, is fundamental in global finance, representing one of the most actively traded and closely monitored currency pairs in the world. Since early 2017, financial markets have observed a notable trend: the depreciation of the US dollar against the euro. This development has surprised many market analysts, central banks, and financial institutions, especially considering the anticipated economic policies of the new US administration at the time. Contrary to expectations of a stronger dollar driven by proposed infrastructure investments, tax reforms, and deregulation, the dollar weakened. This unexpected behavior raises significant questions, given the US dollar’s pivotal role in the international economic system (Boz et al. 2018).
This article explores the factors behind these surprising shifts in the dollar–euro exchange rate. It argues that fluctuations in this rate can be largely attributed to changes in two key interest rate spreads. This analysis provides valuable insights, especially in light of research highlighting the difficulty in accurately forecasting the dollar–euro exchange rate out-of-sample (Cheung et al. 2017).
The Initial Puzzle: Dollar Depreciation Post-Trump Election
Initially, following President Trump’s election, the market anticipated that his administration’s economic agenda would stimulate US economic growth and inflation. This expectation led to a natural assumption of a strengthening US dollar.
Figure 1 US dollar–euro rate and German–US 10-year spread
As Figure 1 illustrates, in the immediate aftermath of the November 2017 election, the dollar did indeed appreciate against the euro, moving from $1.10 per euro in October to $1.05 by December. This period also saw a sharp increase in US interest rates as markets reacted to the anticipated economic policies. Consequently, the spread between German and US 10-year government bond yields narrowed, falling from -1.76% in October to -2.24% in December. This initial phase aligned with expectations: President Trump’s election led to higher US interest rates and a stronger dollar.
However, from January to September, this trend reversed. The interest rate differential favoring the US diminished to 1.85%, and the dollar depreciated to $1.19 per euro. Several factors likely contributed to this shift. Firstly, it became apparent that the implementation of President Trump’s economic program was slower and less definitive than initially projected. Secondly, the Eurozone experienced stronger economic growth, coupled with improved political sentiment towards the euro following key European elections in the Netherlands, France, and France (parliamentary), where Eurosceptic parties did not gain ground.
Interestingly, from October onwards, the previously observed correlation between the exchange rate and the German-US interest rate spread weakened, suggesting other factors might be at play.
Considering Eurozone Bond Yields: The Role of Peripheral Spreads
While the German-US bond yield spread is a significant factor, it is also important to consider the yields on government bonds from financially weaker Eurozone countries, particularly those in the periphery. Concerns regarding public debt or political instability in these nations can cause their long-term bond yields to rise, potentially leading to euro depreciation.
To investigate this, Figure 2 examines the spread between Spanish and German bond yields as an indicator of yield movements in the Eurozone periphery.
Figure 2 US dollar–euro rate and Spanish–German 10-year spread
Figure 2 reveals a degree of correlation between the EUR/USD exchange rate and the Spanish-German yield spread. Notably, the euro’s strengthening towards the end of the sample period coincided with a decrease in the Spanish-German yield spread, from 130 basis points to approximately 85 basis points. This suggests that a narrowing periphery yield spread can contribute to euro appreciation.
Quantifying the Impact: Regression Analysis of Interest Rate Spreads
To further analyze these relationships, monthly changes in the two interest rate spreads (German-US and Spanish-German) were computed and compared with the monthly percentage change in the EUR/USD exchange rate. The analysis revealed a strong positive correlation of 0.79 between changes in the German-US spread and the exchange rate change. Furthermore, a significant negative correlation of -0.53 was found between changes in the Spanish-German spread and the exchange rate change.
A regression analysis was then conducted, using changes in the German-US spread and the Spanish-German spread to explain changes in the exchange rate. The results indicated that these two interest rate spreads accounted for 78% of the variation in the EUR/USD exchange rate. The effects were also statistically significant and aligned with economic theory. A 10 basis point increase in German yields relative to US yields was associated with a 1.1% appreciation of the euro. Similarly, a 10 basis point decrease in Spanish yields relative to German yields led to a 0.6% euro appreciation.
Figure 3 visually represents the changes in the EUR/USD exchange rate and the portions attributed to changes in the German-US and Spanish-German yield spreads.
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
As depicted in Figure 3, changes in the German-US yield spread appear to have been the dominant factor influencing the EUR/USD exchange rate from late 2016 to October 2017. Changes in the Spanish-German yield spread also played a significant role, particularly in early 2018.
This analysis suggests that the dollar’s depreciation in 2017 was largely driven by an increase in German long-term bond yields relative to US yields, and a decrease in Spanish long-term yields relative to German yields. While the sample size is limited to 17 data points, these findings offer valuable insights into the dynamics of the EUR/USD exchange rate.
Broader Implications and Long-Term Analysis
To assess the broader applicability of this model, it was re-estimated using data from the euro’s inception. This longer-term analysis indicated the need to include a lagged dependent variable in the model. With a larger dataset of 228 observations, the explanatory power decreased to 22%. However, the estimated impact of changes in the German-US and Spanish-German spreads remained statistically significant. Importantly, tests for structural breaks did not indicate any instability in the model’s parameters over time.
Conclusion: Interest Rate Spreads as Key Drivers of EUR/USD
In conclusion, this analysis strongly suggests that a significant portion of the fluctuations in the US dollar against the euro since President Trump’s election can be attributed to shifts in the relative attractiveness of holding US dollars versus euros. These shifts are primarily reflected in the interest rate differentials between German and US bonds, and to a lesser extent, in the yield spreads within the Eurozone periphery. Understanding these interest rate dynamics is crucial for interpreting and potentially anticipating movements in the euro to dollar 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.
