In a previous article it was illustrated how, in the medium to long term, the value of a currency is a function of a series of variables, such as the growth prospects of the economy (real and nominal) to which the currency refers and the political risk (or country risk – the potential change in the economic and political context) of the country or macro-area in question.
The objective of this analysis is to use a synthetic measure that includes a set of variables, such as future real growth, expected inflation and the country risk of two macro-areas, to better understand the trend of the respective currencies of reference.
In this regard, we believe that “the differential of the slopes of the curves of the nominal interest rates of the government bonds of the reference macro-areas” can be a good synthetic tool to achieve the goal we have set.
Why the slope of the interest rate curve
We know that the slope of the nominal rate curve, or the differential between the government rates of long and short maturities, has always been considered one of the main indicators to understand which phase of the economic cycle we are in.
Specifically, a good predictive ability of the indicator (the slope of the curve) has been found over time when values close to zero or negative have been reached; historically, this situation has often been followed by a recessionary economic phase.
To understand this phenomenon, it is first of all necessary to remember that central banks, in the various phases of the economic cycle, by lowering and raising interest rates, directly “control” the short-term part of the curve even if their actions have an indirect effect on the long one.
The process and the decisions that lead to the transition from an expansionary to a restrictive monetary policy phase proportionally affect the short part of the curve (here we usually start from a very low rate, usually close to zero) than that the long one. Consequently, the differential (the long minus part short part) goes from being very large in the expansion phase, to then drop to zero or even reach negative values in the restrictive phase. This rise and fall of the nominal rate curve is the result of the action of central banks and, given that we are talking about nominal rates, it should incorporate both expectations of future growth and those of expected inflation.
In light of the foregoing, let’s try to analyze the trend of the cross eurodollar exchange rate and try to understand the relationship that exists with our synthetic indicator.
Let us immediately remember that when analyzing a cross exchange rate between two currencies, we refer to a relationship, that is, the relative strength between one currency and another. Relative logic is very important because in the cross we have to compare the differences in the economic prospects (real and nominal) and in the country risks of the countries or macro-areas we are studying.
Relative US – Euro Blend slope vs Euro/$
From the above chart you can see the positive aspect or that the correlation between the two series, the delta of the inclinations of the American curves with that of the Euro Blend and the trend of the Eurodollar is significant (R2=76); the negative is that the period of strong correlation is short, only three years. Let’s analyze it.
The pre-Covid period, i.e. from July 2019 to March 2020, the delta of the slopes of the respective curves is stable and negative and oscillates in a range between -50 and -20bps approximately (therefore the european inclination is steeper than the american one) . Then the “reflation phase” starts where the Fed takes the lion’s share with rate cuts and QE in relative “more aggressive” than the european one: it is for this reason that an increase in “global dollar liquidity” is generated and the consequent weakening of the dollar against the euro. We can outline the reflation peak and subsequent stabilization between April / May and July 2021 (spread curves between +50 and + 100bps). After that, the market is already starting to position itself (in advance of central banks) for a withdrawal of liquidity and a rise in interest rates with the consequent reduction of “global dollar liquidity” and simultaneous strengthening of the dollar against the euro. In fact, the spread starts from being positive (+ 100bps) to become clearly negative (-140bps): the strong re-pricing of american interest rates compared to european ones affects the movement of the slopes of the respective curves of the relative government bonds.
In light of all that we have explained, we can say that today the current euro / dollar exchange rate around parity seems to be priced correctly, since the two series, as can be seen from the above chart, are aligned. This should mean that the eurodollar reflects the relative attitude of the respective central banks, the delta of real growth, the expected inflation and the political risk.
Recall, however, that the war in which the Fed and the ECB are engaged in trying to maintain a difficult balance between the declared fight against inflation (interest rate hikes) and the attempt to prevent their economies from running into a recession is not over yet. In particular, that the ECB is managing a much more vulnerable area from an energy point of view (the Ukrainian-Russian conflict has uncovered its nerves) and at the same time must prevent the “fragmentation risk” from affecting its action of monetary policy. The success or failure in this difficult task will determine the future trend of the euro dollar exchange rate.