n our last edition of Foreign Exchange Insights, we discussed how Central Bank Policies have impacted Foreign Exchange rates. We discussed the recent measures the European Central Bank took, as well as those taken by the Japanese Central Bank. In this edition we are going to continue with our Central Bank focus, but we will focus on the steps the US Federal Reserve Bank is taking. We will discuss the impact that it is having on the FX Markets.
After reading Jim Anderson’s excellent article on Bernanke’s Bear Baiting, I thought it might be constructive to look at the specific impact of Federal Reserve Policy on the EUR – USD currency pair. Right now the Federal Reserve is engaged in a Quantitative Easing program where it is purchasing $85 billion worth of securities a month. They are purchasing $45 billion a month of longer term US Treasury securities and $40 billion a month of mortgage-backed securities. The goal is to bring down interest rates enough to encourage corporate and consumer borrowing, all in an effort to help spur economic growth.
Below is a chart of the EUR – USD currency pair. You will notice that on June 19th, before the Federal Reserve released its Policy Statement, the EUR – USD was trading near its recent highs, right around 1.3400.
On June 19th, when the Federal Reserve released its Policy Statement, it included a consensus view that the job market was strengthening and downside risks to the economy and the labor market have diminished since last fall. Also, in the press conference after the release of the statement, Chairman Bernanke said that it “might be appropriate to moderate the monthly pace of purchases later this year.”
The timing of the tapering of asset purchases by the Federal Reserve took the markets by surprise and, as a result, US interest rates rose swiftly and quickly all across the curve. Generally speaking, higher interest rates are supportive of a currency. As you can see, after the Policy announcement the EUR – USD currency pair traded off. The result was the USD strengthening 5 % versus the EUR. One thing we can take from the price actions in FX, Equities, and Bonds is that any reduction in Quantitative Easing Policy by the FED makes the markets queasy.
Let’s now focus on July 9th, when the minutes of the June 19th Federal Reserve Policy meeting were released. The minutes provided a more in-depth look into the discussions among the meeting participants. The minutes showed there was far less consensus regarding the policy decision in the June meeting than the market thought. The minutes suggested policy makers wanted to see more labor market improvement before any tapering would begin. This was not apparent in the June Policy Statement or the following press conference.
Below is a chart of the EUR – USD after the release of the minutes on July 9th. Since then, the USD reversed all of the gains from the June meeting and lost 5% versus the EUR. We are right back to the June levels.
As you can see, FED Policy has had a direct impact on Foreign Exchange rates. Central Bank Policy decisions are but one ingredient that makes up the world of Foreign Exchange. 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.
The next question is where does the EUR – USD currency pair go from here? Obviously, future guidance on monetary policy from the Federal Reserve and the European Central Bank will have an impact. We also have to look at economic growth in the US as well as EURO zone economic growth. Another situation to keep an eye out for in near future is the reemergence of the European Debt crisis. Both Portugal and Greece will need more aid in the near future. On balance, I believe that the USD will slowly strengthen versus the EUR towards year end.
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