Don’t Bet on the Euro to Dollar Exchange Rate
The euro to dollar exchange rate did something really strange this week, as investors showed mixed feelings for Europe’s outlook. European Central Bank (ECB) President Mario Draghi unveiled a new stimulus package to aid Europe’s flailing economy, but it fell short of market expectations. Mysteriously, this caused the EUR/USD exchange rate to soar.
That wouldn’t normally happen, since pessimism over a currency’s fate usually makes its value drop. Yet the euro to dollar outlook rose by more than three percent in a single day. Why did that happen? And more importantly, what does it mean for the EUR/USD outlook in 2016? The answers to both those questions lie in the murky and arcane field of monetary policy.
Mapping out the EUR/USD Exchange Rate in 2016
Here’s the difference between the ECB and the Federal Reserve: the Fed did three rounds of massive stimulus that helped weaken the U.S. dollar enough to revive manufacturing, while the ECB shied away from doing the same thing. As a result, the eurozone’s industry remains in the doldrums.
It’s completely obvious to anyone who was watching that the U.S. dollar was going to rebound quicker than the euro. Ultimately, a currency should reflect the strength of the underlying economy, which means the euro to dollar relationship could soon collapse.
Investors were looking to Mario Draghi to increase the ECB’s purchases of assets to €60 billion a month and cut interest rates by 0.15%. In fact, the euro dropped significantly in the last two weeks because markets were convinced that Draghi was going to boost his stimulus package. (Source: “Stocks Plunge With Dollar, Bonds as ECB Decisions Disappoint,” Bloomberg, December 2, 2015.)
Central Banks to Keep Driving EUR/USD Rate
The broad purpose of a central bank is to try and smooth out the rough patches of a business cycle. There’s a lot of economic evidence that booms and busts are a natural feature of capitalism and that they’re simply things we should expect from time to time.
However, the bust part of the cycle can be devastating to a country. It can push millions into poverty, cause a spike in unemployment, and destroy billions of dollars in wealth. To limit the damage, central banks step up and do their thing.
Both the European Central Bank and the Federal Reserve reacted to the 2008 financial crisis, but their responses differed enormously. As a result, one economy recovered and the other did not. The euro and U.S. dollar are proof enough of that.
Don’t believe this move; Thursday’s EUR/USD rally is just a head fake.