In the past, when we look at the two episodes of strong U.S. dollar, it happened when the U.S. real interest rates were higher than elsewhere: 1982-85 and in 1995-2001.
Between 2003 and 2008, the dollar was weak when U.S. real rates were broadly lower than in the Eurozone.
Between 2009 and 2010, USD weakness resumed as U.S. reduced nominal rates to zero and real rates were negative, more negative than in the Eurozone.
Between 2010 and 2013, the EURUSD stayed broadly stable but the negative relationship with the USA-Euro real rates was maintained.
Between 2013 and 2016, US dollar was strong not so much because U.S. real rates went up but real rates in the Eurozone were much lower. In other words, the differential moved in favour of the U.S. and hence EURUSD weakened. Again, the negative correlation was maintained. But, the anomaly started in Dec. 2016. The two lines – red and blue are correlated positively!
See the two charts below. One is the long-term chart and the second chart is for the more recent period.
Even though Ms. Yellen has softened her interest rate increase talk, as he writes, the U.S. real rates have trended higher compared to the Eurozone. The Eurozone is nowhere near beginning to think about the matter.
Further, even Fed balance sheet reduction in the U.S. should see a tightening of rates.
So, to sum up, why is EURUSD moving higher even as the real rate differential is moving in favour of US dollar?
(1) Perception of competence, leadership and decisiveness strongly favours Eurozone political leadership than the American leadership, including the Congress.
(2) In political and policy leaderships in both the regions – America and the Eurozone – there is no constituency that objects to the current trend in EURUSD. Germany does not mind a stronger EURO. It has a current account surplus of 8.5% of GDP. It does not want to stimulate the economy by spending more. The economy does not need stimulus. It is growing nicely. Germany hates to become fiscally profligate because of long-term fiscal sustainability. Any faster growth would stoke inflation concerns. Better to let the currency appreciate and it would also make the American President less critical of the exchange rate.
(3) Should the stock market crash in the U.S., and globally, there is a recession or slowdown combined with rising risk aversion, it usually makes the dollar stronger. But, we never know about the future. This time, clearly Yellen would turn around and go back to easing. But, for the Eurozone, there will be no change in policy. So, therefore, at the margin, the policy would turn easier in the U.S. with no change in the Eurozone. That too is negative for the U.S. dollar.
[Important: this is not an investment recommendation. Just some loud thinking on the EURUSD exchange rate. Nothing more. ]