Wednesday, February 8, 2017

The Euro Tracks U.S. Yields, Not German Yields

From the Asia Times, Feb. 1:

The US dollar in Navarro-Navarro Land
Peter Navarro, an adviser to President Donald Trump, told the Financial Times (subscription) Jan. 31 that Germany is using a “grossly undervalued” euro to “exploit” the United States. During a meeting with US business leaders, President Trump echoed Navarro’s remarks, complaining that “we sit here like dummies” while other countries manipulate their currencies.
This view is sadly at variance with all the observed facts.
The US dollar is strong and the Euro is weak because the Federal Reserve has been raising US interest rates and is expected to raise them further. The dollar is the world’s largest capital market. The dollar dog wags the euro tail. During the past three years, virtually all the change in the euro-dollar exchange rate is explained by the expected overnight interest rate set by the Federal Reserve (the federal funds rate) 12 months hence. The futures market for federal funds tells us what the market thinks the Fed will do....
Federal funds futures (expected Federal Reserve policy) explain the exchange rate between the US dollar and the euro. The chart above shows daily data for the past three years (from Bloomberg). As Fed policy has tightened, the dollar’s exchange rate has risen. Dollar holders receive higher interest rates vs. euro dollars, so investors shift deposits from euros to dollars. That’s what the textbook says should happen. I presume that is true even at Harvard, where Peter Navarro studied....
The euro exchange trade has a straight-line relationship to the US 10-year yield, but little relationship to the German 10-year yield