The unexpected weakening of the US dollar against the euro since early 2017 has sparked considerable debate among market observers, central banks, and financial institutions alike. Following President Trump’s election, conventional wisdom suggested that his administration’s proposed economic policies – including infrastructure spending, tax cuts, and deregulation – would bolster the dollar’s value. However, the opposite occurred, raising concerns given the dollar’s pivotal role in the global financial system.
What factors explain this counterintuitive movement in the Dollar Vs Euro exchange rate? This article argues that shifts in interest rate differentials between the US and the Eurozone largely account for these exchange rate fluctuations. This analysis is particularly relevant considering previous research highlighting the difficulty in predicting dollar-euro exchange rate movements outside of sample data.
A logical starting point is to examine the relationship between the dollar vs euro exchange rate and the interest rate gap between the US and the euro area.
Figure 1 US dollar–euro rate and German–US 10-year spread
Figure 1 illustrates the dollar’s initial appreciation following President Trump’s election in November 2016. The dollar strengthened from $1.10 per euro in October to $1.05 by December, coinciding with a rise in US interest rates. Market anticipation of President Trump’s growth-oriented and potentially inflationary economic agenda fueled this rate increase. Consequently, the spread between German and US 10-year government bond yields narrowed from -1.76% in October to -2.24% in December, demonstrating an initial strengthening dollar alongside rising US rates relative to German rates.
However, from January to September 2017, this trend reversed. The interest rate differential favoring the US contracted to 1.85%, and the dollar depreciated to $1.19 per euro. This shift can be attributed to two primary factors. Firstly, it became increasingly apparent during the spring of 2017 that President Trump’s economic program faced implementation hurdles and delays. Secondly, the Eurozone experienced a period of robust economic growth, coupled with improved political sentiment following key European elections in the Netherlands and France, which diminished euro-skeptic political influence.
Interestingly, the strong correlation between the exchange rate and the German-US interest rate spread weakened from October 2017 onwards, suggesting other factors might be at play.
It’s crucial to consider that bond yields from financially weaker Eurozone countries may also influence the dollar vs euro exchange rate. Concerns regarding public debt or political instability in these nations could lead to higher long-term yields, potentially weakening the euro.
To investigate this, Figure 2 presents the spread between Spanish and German bond yields, serving as an indicator of yield trends in the Eurozone periphery (note the inverted scale). The figure reveals a degree of correlation between this spread and the dollar vs euro exchange rate. Notably, the euro’s strengthening at the end of the examined period coincided with a decrease in the Spanish-German yield spread, from 130 basis points to approximately 85 basis points, a factor that would typically contribute to euro appreciation.
Figure 2 US dollar–euro rate and Spanish–German 10-year spread
To further analyze these relationships, monthly changes in both interest rate spreads and the monthly percentage change in the exchange rate were calculated. The correlation between changes in the German-US spread and changes in the exchange rate is notably high at 0.79 and statistically significant. Similarly, the correlation between changes in the Spanish-German spread and changes in the exchange rate is -0.53, also statistically significant.
Employing regression analysis with these two interest rate spreads as explanatory variables, we find that they account for 78% of the variation in the dollar vs euro exchange rate. Furthermore, the impact of these spreads is 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 (t = 8.5). Conversely, a 10 basis point decrease in Spanish yields relative to German yields leads to a 0.6% euro appreciation (t = 4.1).
Figure 3 visually decomposes the monthly changes in the dollar vs euro exchange rate into components attributed to changes in the German-US and Spanish-German yield spreads. The analysis suggests that fluctuations in the German-US spread were the dominant factor driving exchange rate movements from late 2016 to October 2017. Changes in the Spanish-German yield spread also appear to have 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 indicates that the dollar’s depreciation in 2017 was largely driven by rising German long-term bond yields relative to US yields and falling Spanish long-term yields (as a proxy for the Eurozone periphery) relative to German yields. While the sample size is limited to 17 data points, further investigation using a longer dataset since the euro’s inception reinforces these findings. Expanding the analysis reveals that a lagged dependent variable is necessary for model robustness. Although the explanatory power decreases to 22% with 228 observations, the estimated impact of the German-US and Spanish-German spreads remains highly significant, and no evidence of structural breaks is detected over time.
In conclusion, the primary takeaway from this analysis is that a substantial portion of the dollar vs euro exchange rate fluctuations following 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.
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.
