This Great Graphic, created on Bloomberg, shows two time series. The bar chart is the dollar against the euro (the inverse of the conventional euro rate against the dollar). The line is the 2-year interest rate differential between the US and Germany.
We have shown the chart before, but thought it worth updating as it remains a close fit.
The dollar fell against the euro the divergence between the Fed continued and more aggressive easing and the ECB which was on hold, with seemingly fading need to operationalize the Outright Market Transaction scheme became clearer. On top of that there was a passive tightening of monetary conditions in the euro area as banks borrowed less from the ECB and began repaying the long-term repo borrowings.
The premium the US offered over Germany fell from over 30 bp in mid-December to more than a 2 bp discount by late January. The dollar fell in lockstep. The differential has been trending back into the dollar's favor in a saw tooth fashion since the start of the month. At first, the market seemed to be considering how the ECB was to respond to the passive tightening and the rise of the euro. Talk of a rate cut resurfaced.
Last week we learned that the repayment of the second LTRO was much less than expected; meaning that the financial conditions were not tightening as much as investors may have feared. Now the Italian elections have rekindled worries about a systemic crisis and has seen safe haven flows back into the short-end of the German curve.