Yesterday’s ECB (European Central Bank) meeting was the main event of the week. All eyes were on Draghi and the monetary policy conditions to be announced.
As such, the Euro was in focus starting with Wednesday. And, it didn’t disappoint.
For the whole summer, the EURUSD pair moved in an almost vertical line. It rose from 1.05 to 1.20 in less than five months.
While such moves are not uncommon in the Forex market, they’re not that common for a dollar pair. Many traders tried to fade the move and sold new highs. However, new buyers stepped in on each and every dip.
But why would the EURUSD surge so dramatically?
The Interest Rate Differential
One reason would be the interest rate differential. The only thing is, it should have favored the dollar. Not the Euro.
While the interest rate in the United States rose to 1%, it is still negative in the Eurozone. As such, the interest rate differential should favor the U.S. dollar. Not the Euro.
Yet, the EURUSD pair rose dramatically. The thing is that Forex traders focus on expectations more than on the actual situation.
And, for the whole summer, the signs from the Eurozone economy were positive. Unemployment dropped, GDP (Gross Domestic Product – the total value of goods and services) rose, industrial production as well, PMI’s look good…all signs of a strong and healthy recovery.
Because of that, trader’s expectations grew that the ECB will react. And, that the Fed won’t do anything moving forward.
As such, if the ECB will start tightening the monetary policy (reducing the size of the quantitative easing program), the interest rate differential will shrink. And that’s what drove the Euro higher.
This Week’s ECB Meeting
To many people’s disappointment, the ECB didn’t deliver. Not that traders expected new measures to be announced this week.
But, at least a hint at what’s about to come. Instead, the ECB chose the path of least resistance. Let’s sit and wait and see what will happen.
All bets are now on the January meeting. It is supposed to bring a schedule for the ECB to reduce the bond buying program.
This, alone, is bullish for the Euro. Will send the EURUSD skyrocketing higher. However, only if the Fed won’t change anything. But this is unlikely.
Comes Fed into Discussion
Following the 2008 financial crisis, the Federal Reserve of the United States (Fed), embarked on various monetary policy programs. All destined to ease the monetary conditions.
As a result, the dollar weakened. Moreover, the Fed’s balance sheet increased exponentially.
Now, the Fed started to tighten the monetary policy. It hiked the interest rates four times, lifting it from zero to 1%.
Furthermore, it vowed to start unwinding the balance sheet. Therefore, it will start selling the bonds in its portfolio.
Of course, this will be a gradual process. But, it has a tightening effect on the monetary policy.
No matter how you put it, the Fed seems to be, again, ahead of the curve. While the Euro buyers base their trades on future expectations, dollar bulls look at what happens with the Fed’s actions.
However, there’s one wild card that doesn’t shows up neither in Eurozone nor in the United States. That’s inflation.
If, when and were inflation will pick up first, that’s where the money will flow. Because expectations will grow that the respective central bank will tighten the monetary policy faster. Hence, the cost of money will rise.