The euro shot above its 200-day moving average last week for the first time since May 2014. By the end of the last week it was back below it. It is found just below $1.13 today, and was surpassed earlier today.
There are many factors that investors are wrestling. Some are technical like market positioning. Some of macroeconomic in nature, like the impact of the market volatility and developments in China on the timing of the Fed’s rate hike. Officials that spoke at and around the Jackson Hole conference appeared to remain committed to raising rates this year. There are three meetings left: September, October and December.
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One of the economic variables that are in numerous econometric models of the euro-dollar exchange range is short-term interest rate differentials. We often have found that the 2-year interest rate differential is a helpful guide. The Great Graphic, created on Bloomberg, shows the euro (yellow line, left hand scale) and the German discount to the US on two-year borrowing (white line, right hand scale).
Correlations are notoriously difficult to eyeball. Over the past 60-days, the correlation conducted on the basis of percentage change of euro and the percentage change in rate differential has risen to a little over 0.60. This appears to be the strongest correlation since at least mid-September 1995, when the Bloomberg data began. It had neared such a tight fit in 2006 (correlation was ~0.58) and in 2012 (correlation was ~0.56).
The two-year interest rate differential is around 92 bp presently. This is not very extreme for the spread. In the early 1990s, Germany was paying a premium over the US. In 1992 it reached 525 bp. In the late 1990s, a US premium had been restored. It reached 270-290 bp in the US favor in 1997-1999. The change rather than the level seems to be the important element for the euro-dollar exchange rate.
The relationship between the euro and the two-year interest rate differential cannot simply be reduced to the vagaries of Fed expectations. To test that hypothesis, we ran the correlations of the percentage change in the euro and the percentage change of the December 2015 Eurodollar futures contract. Over the past 60 days, the correlation is about 0.46.
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