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Central Bank Polices Continue to Impact Foreign Exchange

May 9, 2013

One of the highlights of last week was that the European Central Bank cut its benchmark policy rate by 25bp, to 0.5%, to counter mounting disinflationary pressure resulting from the ongoing euro area recession, with economic weakness increasingly spreading to core member states (Germany and France specifically) . The rate cut had been widely anticipated and largely priced in and the EUR – USD currency pair traded off slightly on the news. Also the euro area unemployment rate rose 0.1pp to 12.1% in March, reaching a new all-time high since the series started in 1993. It is not widely anticipated that the Labor market will improve significantly any time soon in the EUR area.

The EUR has remained relatively immune to the weak growth outlook in the Eurozone. This may seem slightly strange given the ECB has just eased policy, (generally cutting interest rates is not supportive of the currency hence you would expect the EUR to sell off) but on a global basis a 25bp rate cut pales in significance to the Quantitative Easing and asset purchase programs being conducted by the US, UK and Japanese Central Banks. This is one reason the EUR did not sell off aggressively after the rate cut announcement on Thursday.

Below is a chart of the EUR – USD currency pair. As you can see we have rebounded from the 1.2700 level. This is partly due to some weaker than expected US data earlier in the month but another major reason for the recent rise has to do with Japanese Central Bank Policy. I will expand upon this in a moment but I want to highlight the exact day the EUR bottomed out. You will notice that the date is April 4 2013. Sometimes other Central Bank Policy decisions can have a major impact on your currency.

On April 4th the Bank of Japan delivered a much larger than expected package of easing measures. Although they did not explicitly state it in their policy, one of the biggest goals was to weaken the Japanese currency. The currency markets got the message and the following two charts will reflect that.  Here is the chart of the USD vs JPY.  Before the announcement USD/JPY was trading around 92.50 and now we are trading around the 99 level trying to break through 100. The JPY has weakened 7% since the announcement.

Next is a chart of the EUR/ JPY.   On the day of the announcement the currency pair was trading at 119 and now we are trading at 130. The JPY has depreciated against the EUR over 9.2% since then. So as you can see the JPY has depreciated more versus the EUR than versus the USD.

The significant exchange rate movements that occurred right after the Bank of Japan easing measures were announced highlights the significance that Central Bank Policy measures can have on the volatility of foreign exchange rate fluctuations.  In the coming weeks we will see how the intended and the unintended consequences of these Central Bank  Policy decisions play out in future exchange rate movements. Central Bank Policy decisions are but one ingredient that makes up the wonderful world of FX. Economic data, interest rates, commodity prices, trade flows, bond and equity flows as well as many other factors all combine to determine foreign exchange rates.  Reading the tea leaves is what the game is all about!!!

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