Euro Higher, but the Fed is going to Taper

The euro is flirting with $1.38.  Many, including ourselves, have been surprised by the euro's strength in H2 and its persistence.  The net speculative futures position briefly moved switched to the short side in late November.

Growth differentials and the trajectory of monetary policy are in the dollar's favor, no ?   The situation seem more complicated now.    When considering the near-term outlook for the euro-dollar exchange rate, we have often found the 2-year interest rate differential to be particularly useful.  Despite ideas of Fed tapering, the US premium is the smallest since February.

This Bloomberg chart shows the 2-year differential (white line) and the dollar against the euro (inverse of euro vs dollar, in yellow).  It shows that the dollar's decline has coincided with the US interest rate premium falling relative to Germany.

Over the past month, the US 2-year yield has fallen a little more than 1 bp, but the German 2-year yield has risen 14 bp.   Unlike in September, the market has come to grips with the fact that tapering is not tightening.  In early September, the 2-year yield approach 50 bp.  Now it is below 30 bp. 

The German yield rise comes as the ECB downplayed the risk of deflation and refrained from offering new liquidity measures.  Many had expected a new long-term repo operation.  In  addition, EONIA has turned both higher and more volatile.  While some of the upward pressure is due to the year-end, it has begun earlier than last year, has begun at a higher level and is more volatile.  Month-end spikes have been increasingly large since the end of August. 
Euro Higher, but the Fed is going to Taper Euro Higher, but the Fed is going to Taper Reviewed by Marc Chandler on December 11, 2013 Rating: 5
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