A key driver for the US dollar’s recovery in recent months has been the wider interest rate differentials. In this brief note, we review what the linkage between the euro-dollar exchange rate and the nominal and real interest rate differentials.
The euro is beginning this week with a four-week slide in tow. It has depreciated in eight of the past ten weeks. It fell in only three months in 2017 and has already fallen two this year. Nearly halfway through May, the euro is off almost a cent.
Widening interest rate differentials have some explanatory power. When interest rate differentials are moving in the US favor, the euro tends to be weaker, but when the spread stabilizes the euro strengthens.
The 10-year differentials went sideways in November through mid-January. This coincided with the euro’s rise from around $1.1580 in early November to a high above $1.25 in January. The euro recorded its high a little above $1.2550 in mid-February as the 10-year differential widened from about 1.95% in mid-January to 2.17% by mid-February when it traded broadly sideways, through finished March near 2.24%. However, the spread widened in the US favor in April, and the euro broke out of its three-month consolidative phase to the downside. It reached nearly 2.40% in late April. It made a new high near 2.45% last week before easing. It is testing the 20-day moving average just below 2.39% now. As it comes off, the euro is staging a bit of a recovery, and it is gaining for the third consecutive session.
Behind the divergence of interest rates has been the divergence of inflation. In April 2017, US inflation was 30 bp on top of the EMU. This April it stood at 120 bp. It is wider than any time in 2017. It briefly was at 132 bp in April 2016. That was the largest inflation differential since 2014 when it was more than 150 bp for the first time since reached 180 bp in late 2009. The chart here, created on Bloomberg shows the US-EMU inflation differential going back to 2001.
Deflating the EMU nominal yield by headline CPI indicates a real rate of about minus 65 bp. It bottomed in February 2017 near -180 bp. The 12, 24, and 60-month averages converge around current reading.
Deflating US nominal yields by headline CPI shows US real rates bottomed in September 2011 near minus 215 bp. It peaked in 2015 above 230 bp. In 2016 and 2017, the real 10-year US yield was mostly between zero and 1.0%, though at the end of 2016 and to the middle of Q1 17, the real rate has trading as low as minus 37 bp. More recently, it has put in the low for the is year in early April near 27 bp. The 30 bp recovery since has coincided with the dollar’s recovery.
In the futures market, speculators have added to their gross long euro position for the past two CTFC reporting periods and four of the last six. They have seen the pullback in the spot as a new buying opportunity. The gross long position of 226k contracts is the largest on record, except for Q1 18. The bears have grown their speculative gross short position over the past two weeks to a little more than 107k contracts. The gross short speculative position peaked this year in late January near 117.5k contracts.