Dollar Compared to Euro: Unpacking the Dynamics of the Exchange Rate

The relationship between the US dollar and the euro is a cornerstone of the global financial system. Since early 2017, financial markets have observed a notable trend: the US dollar depreciated against the euro, a movement that surprised many analysts, central banks, and financial institutions. This was particularly unexpected given the prevailing sentiment following the election of President Trump. The anticipated economic policies, including infrastructure spending, tax reforms, and deregulation, were widely predicted to strengthen the dollar. However, the opposite occurred, raising questions about the underlying factors influencing this crucial exchange rate. Understanding these dynamics is vital, given the dollar’s central role in international trade and finance.

What factors can explain this unexpected shift in the dollar-euro exchange rate? This analysis argues that fluctuations in interest rate spreads are the primary drivers behind these movements. This perspective offers valuable insight, especially considering prior research highlighting the difficulty in accurately forecasting the dollar-euro exchange rate.

It’s logical to begin by examining the exchange rate in conjunction with the interest rate differential between the United States and the Eurozone.

Figure 1 illustrates the US dollar–euro exchange rate alongside the spread between German and US 10-year government bond yields. Following President Trump’s election in November 2016, the dollar initially strengthened, moving from $1.10 per euro in October to $1.05 by December. This appreciation coincided with a sharp increase in US interest rates, fueled by market expectations that President Trump’s policies would stimulate economic growth and inflation. Consequently, the spread between German and US 10-year yields widened, moving from -1.76% in October to -2.24% in December. This period demonstrates the conventional relationship: the anticipation of President Trump’s economic agenda led to higher US interest rates and a stronger dollar.

However, from January to September 2017, this trend reversed. The interest rate differential favoring the US narrowed to 1.85%, and the dollar depreciated to $1.19 per euro. Two primary factors likely contributed to this shift. Firstly, it became increasingly apparent during the spring of 2017 that President Trump’s economic program faced implementation challenges and delays. Secondly, the Eurozone experienced stronger economic growth, and investor confidence in the euro improved following key European elections. The Dutch parliamentary elections in March, the French presidential elections in April and May, and the French parliamentary elections in June all saw losses for Eurosceptic political parties, bolstering sentiment towards the euro.

Interestingly, from October 2017 onwards, the correlation between the exchange rate and the German-US interest rate spread weakened, suggesting other factors might be at play.

Beyond core Eurozone economies like Germany, the bond yields of governments in the Eurozone periphery, particularly those with weaker financial positions, can also influence the exchange rate. Concerns regarding public debt or political instability in these countries can lead to increased long-term yields and potentially contribute to euro depreciation.

To investigate this further, Figure 2 presents the spread between Spanish and German bond yields, serving as an indicator of yield movements in the Eurozone periphery (note the inverted scale). The figure reveals a degree of correlation between this spread and the dollar-euro exchange rate. Notably, the euro’s strengthening towards the end of the sample period occurred alongside a decrease in the spread between Spanish and German yields, from approximately 130 basis points to 85 basis points. This movement aligns with the expectation that a narrowing periphery yield spread would support euro appreciation.

To quantify these relationships, we analyze the monthly changes in both interest rate spreads and the monthly percentage change in the exchange rate. 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 reveals that they account for a substantial 78% of the exchange rate’s variation. Furthermore, the effects are both statistically significant and economically plausible. Specifically, 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.

Figure 3 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 spread. The analysis indicates that changes in the German-US spread were the dominant factor influencing the exchange rate 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.

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, representing the Eurozone periphery. While the sample size is limited to 17 data points, potentially limiting the robustness of these findings, the strong correlations and statistical significance offer compelling evidence.

To assess the broader applicability of this model, extending the analysis beyond this specific period is crucial. Re-examining the model using data since the euro’s inception reveals the necessity of incorporating a lagged dependent variable to improve model fit. With a larger dataset of 228 observations, the explanatory power reduces to 22%. However, the estimated coefficients for the German-US spread and the Spanish-German spread remain highly significant. Importantly, tests for structural breaks do not indicate parameter instability over the longer time frame.

The key takeaway from this analysis is that a significant portion of the dollar-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 spreads.

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.

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