Since the euro’s inception in 1999, the euro-U.S. dollar exchange rate (EURUSD) has been the world’s most widely traded currency pair. During its first 16 years, it traded in wide ranges, from a low of almost 0.8 to a high of nearly 1.6 dollars to the euro. For the past six and half years, however, EURUSD has settled into a much narrower band from 1.04 to 1.25.
Options markets reflect this lack of a breakout trend. Prior to 2016, 30 day at-the-money (ATM) options on EURUSD often traded in the 10-15% implied volatility range, occasionally venturing higher than 25%. In the last several years 30-day ATM options have often traded in the 5-10% implied volatility range, and so far in 2021 have mostly been in the 5-6% range (Figure 1). In other words, not only has historical volatility fallen, but investors don’t perceive a great deal of exchange rate risk going forward.
Data from the commitment of traders (COT) report also suggests that “leveraged” investors, which includes hedge funds, have a relatively neutral positioning on EURUSD, especially since the spring of 2020. Asset managers, which are typically institutional investors such as pension funds, insurance companies and endowments, have had structural long positions which they cover through “dealers” (banks and brokerages operating on the sell side), who in turn hedge themselves with an aggregate net short position. The COT data suggests that hedge funds and commodity trading advisers (CTA) don’t hold strong views on EURUSD for the moment (Figure 2).
So, what are the economic forces that govern EURUSD that can explain why it made such enormous moves during its first 16 years, and have been in such tight ranges subsequently? And what do these macroeconomic drivers tell us about the future of EURUSD? Are options not accounting for significant macroeconomic imbalances stemming from the pandemic and their potential to generate significant moves in EURUSD?
Here we identify several macroeconomic drivers of EURUSD that have explained, to varying extents, past moves in the currency pair. These include:
Both budget and trade deficits explain some of the variation in EURUSD over time. The relative budget balances seem to explain a great deal of what happened to EURUSD during its first 16 years. When the euro launched in 1999, the U.S. was experiencing rising budget surpluses at a time when the eurozone nations were still running budget deficits. EUR was weak out of the starting gate, falling from an initial value of 1.17 versus USD in January 1999 to a low of 0.83 in September 2000.
In 2001, things began moving in the opposite direction. With the combination of an economic recession in the U.S., tax cuts and the beginning of the “war on terror,” U.S. budget deficits expanded rapidly in a manner that was not entirely mirrored in the eurozone. Later that decade, the U.S. budget deficit grew to 10% of GDP amid the global financial crisis. All told, between 2000 and 2010, the U.S. went from running much smaller budget deficits than Europe to running much bigger ones, and the U.S. dollar fell by as much as 50% versus the euro from peak to trough.
Between 2009 and 2016, this situation reversed once again. The U.S. budget deficit shrank much more quickly than deficits in the eurozone, and the dollar rebounded accordingly. Since 2016, however, relative movements in budget deficits have not, by themselves, done a great job of explaining the movement in EURUSD. Between 2017 and 2019 the U.S. budget deficit expanded from 2% to 5% of GDP, while eurozone budget deficits continued to narrow. Yet, EURUSD didn’t move a great deal in response to divergent trends in deficit spending. As we will discuss later, during this time monetary policy was pulling in the opposite direction.
Since the pandemic struck, the U.S. budget deficits grew much more rapidly than did deficits in Europe, hitting 20% of GDP, while the eurozone got to just over half that amount. EURUSD did strengthened somewhat, moving towards the top end of its 1.04-1.25 post-2015 trading range, but did not advance further than that. In the last few months, the U.S. budget deficit has begun contracting again while European deficits have been stable and the dollar has rebounded slightly (Figures 3 and 4).
The budget deficit (or surplus) is only one type of deficit. Trade deficits also appear to drive the relative value of the currencies. Since 1999 the U.S. has consistently run trade deficits of between 3% and 6% of GDP. By contrast, the eurozone went from running trade deficits in the 1999-2001 period to running relatively small deficits or surpluses between 2002 and 2011 to consistently running trade surpluses of 2-4% of GDP more recently (Figure 5 and 6). The relative improvement in Europe’s terms of trade may partly explain why EURUSD generally rose from 2000 to the early 2010s.
From 1999 to 2009, U.S. and eurozone monetary policies most often mirrored one another. Both the Fed and the European Central Bank (ECB) tightened in 1999 and 2000 and eased from 2001 to 2003. But during this time, the Fed eased a great deal more than the ECB.
The Fed jump-started its tightening cycle earlier than the ECB in 2004 to 2006. The ECB trailed by about one year, raising rates from 2005 until 2008. Both central banks slashed rates in 2008 and 2009. Since then, however, policies have often diverged. The ECB attempted rate hikes in 2010, while the Fed carefully avoided following suit. The ECB then finally joined the Fed at having zero rates after 2012, and then proceeded to move rates into negative territory, which the Fed also avoided. Instead the Fed began tightening monetary policy in late 2015 and accelerated that tightening in 2017 and 2018 as the U.S. budget deficit expanded. The ECB made no similar move. The Fed then cut rates sharply once the pandemic struck while the ECB could not do anything similar since its rates were already in negative territory when the pandemic began (Figure 7).
EURUSD seemed to lag moves in relative interest rates from 1999 to 2004, but has since more-or-less moved in tandem with them. The only exception was during 2018 when the Fed kept tightening policy but the dollar didn’t rally versus EUR, perhaps because the U.S. budget and trade deficits were pulling even more strongly in the opposite direction (Figure 8).
Market expectations on the direction of U.S. and eurozone rates remain markedly different. Eurodollar futures anticipate that the Fed will slowly raise rates towards 1.5% by the mid-2020s, with rate hikes starting as soon as one year from now. By contrast, Euribor futures price a world in which the ECB might begin easing rates back up towards zero sometime in 2023 or 2024, but that even by 2026 the ECB policy rate will most likely still be in negative territory (Figure 9).
Interest rates are only one aspect of monetary policy. As interest rates have gone towards zero, both the ECB and the Fed moved into quantitative easing (QE), but they haven’t necessarily done their QE programs in tandem. Initially, the Fed was the more aggressive of the two but then the ECB expanded its balance sheet in 2015-18 as the Fed was shrinking its balance sheet. Since the pandemic struck, the ECB has done a lot more QE relative to the size of its economy than has the Fed, a reflection of the fact that the when the pandemic began the ECB’s policy rate was -0.4%, whereas the Fed’s was +1.625%. Prior to the global financial crisis few investors paid attention to the relative size of balance sheets. Since then, relative balance sheet sizes don’t seem to explain EURUSD movements particularly well on their own. That said, taken in the context of the larger expansion of the U.S. budget deficit, the ECB’s relatively larger QE program may explain why the euro has been unable to stage a larger rally versus USD (Figure 10).
There are many proxies for measuring relative economic growth. GDP is an obvious one, but those numbers only come out quarterly. As such, we prefer retail sales, which come out monthly. By this measure, eurozone growth outpaced U.S. growth from 2005 to 2008, as EUR rose towards its eventual peak of nearly 1.6 versus USD. Subsequently, the eurozone was hit harder by the global financial crisis and took much longer to recover than the U.S., particularly from 2011-2013 following the ECB’s abortive attempt to raise interest rates, which brought southern European economies to the brink of collapse. The growth gap may explain, in part, why EUR peaked versus USD in 2008 and then fell so sharply between 2008 and 2015.
Between 2015 and 2019 eurozone and U.S. retail sales grew at nearly identical rates. Both were hit hard in the early stages of the pandemic and both subsequently recovered. However, U.S. retail sales soared far above their previous trendline whereas eurozone retail sales have moved back in line with their previous trend (Figure 11). If one calculates a ratio of eurozone retail sales over U.S. retail sales, the ratio does appear to track the relative value of the two currencies (Figure 12).
Like all exchange rates, EURUSD is governed by a variety of economic factors. Sometimes these factors broadly pull in the same direction and sometimes they operate at crosscurrents. Generally speaking, smaller budget and smaller trade deficits, higher interest rates/tighter monetary policy and stronger growth correlate with a stronger currency. Larger budget and trade deficits, easier monetary policy and weaker growth appear to frequently translate into currency weakness.
EUR’s strength in the period from 2000 to 2008 can be attributed to a eurozone trade deficit that was becoming a trade surplus, smaller budget deficits and stronger eurozone growth as well as relative tightening of monetary policy. EUR’s slide from 2009 to 2015 could be related to a more rapid economic recovery and fiscal consolidation in the U.S. during those years.
From 2015 up till now, different forces have been pulling in different directions, helping to keep EURUSD in a tight trading range. On the one hand, smaller European budget deficits relative to the U.S. and the eurozone trade surplus probably pulled EUR higher versus USD. On the other hand, a tighter Fed monetary policy from 2015 onwards probably pulled EUR back downwards.
Since the pandemic began, the U.S. has run much larger budget and trade deficits, which would normally be negative for the dollar. However, the U.S. has also seen a much stronger economic rebound and markets expect that the Fed will be much quicker to tighten monetary policy than will the ECB, which may have stabilized the dollar and prevented it from falling.
Here are several key questions that may play a role in determining how the interplay of these factors will determine the future course of EURUSD:
The answer to these questions may determine whether the various forces that influence the euro and the dollar will be pulling in the same or in different directions.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.
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