Janet Yellen, Fed chairwoman, on Wednesday voiced the pain the stronger dollar was causing on the other side of the Atlantic, noting how it was hitting US exports. Her comments, together with lower growth and inflation forecasts as well as projections of a much slower pace of Fed monetary policy tightening than previously, may have succeeded in braking the dollar’s advance.
Nevertheless, bafflement over why the euro had fallen so fast against the dollar highlights the disruptive potential of central bank actions; the volatility and uncertainty created by transatlantic divergences is in itself damaging — to economies as well as investors.
The ECB started buying bonds on March 9. Even though its intentions were well known in advance — and could have been priced in — the euro still dropped 4 per cent against the dollar over the next five days, increasing to almost 25 per cent the single currency’s decline since May last year. Falls on such a scale cannot reasonably be considered normal for advanced world economies — but they have become a feature of 2015. The Swiss franc rose as much as 40 per cent against the euro when the prospect of eurozone QE forced Switzerland’s central bank to abandon its cap on the currency in January.
Using estimates of how the euro would have moved if it had existed before 1999, recent falls were greater even than during the early 1990s crisis in the European exchange rate mechanism — the “fixed but flexible” system that was the precursor to the euro. A better comparison are the big currency moves in the early 1980s that led to the Plaza accord, struck 30 years ago at New York’s Plaza hotel, to halt the dollar’s appreciation.
In the 1980s such international agreements had a degree of success in smoothing economic adjustment processes. These days such an approach is unlikely, partly because in the post-2007 crises world the previously abnormal seems normal. More practically, massively expanded capital markets make intervention by central banks in the biggest foreign exchange markets much less likely to succeed, especially if their interests are not aligned.
Central banks around the world are instead engaged in “competitive easing”; Sweden’s Riksbank, for example, this week pushed its main interest rate even deeper into negative territory. Behind the dollar’s recent rise against the euro has been a widening transatlantic interest rate gap. The “spread”, or difference between the yield on 10-year US Treasuries versus German equivalents, had also smashed through levels not seen since the 1980s.
Along with escalating worries about Greece, the trigger for the euro’s unexpectedly dramatic plunge ahead of this week’s Fed meeting may have been a realisation that the ECB was serious about an aggressive QE programme, which would drive an increasing volume of eurozone government bond yields even deeper into negative territory. “It was almost as if markets decided that the starting gun had been fired,” says one currency strategist.
With the Fed meeting helping to narrow transatlantic interest rate differentials, the euro on Wednesday saw its biggest one day jump against the dollar since 2009, before falling back again on Thursday.
Optimists could argue that this year’s trend decline in the euro has been a healthy normalisation process. During its early years, the euro was driven higher as managers of official reserve funds diversified away from the dollar. More recently, it was supported by the ECB’s tardiness in launching QE or — seen from the eurozone hawks’ perspective — the Fed’s tardiness in raising US interest rates. Now, the euro is back to early 1999 levels.
Pessimists, however, will worry about the whiplash moves in the euro-dollar rate, the mesmerising grip central banks hold over financial markets and the abrupt movements they can trigger — with the magnitude of the swings as great as ever as the Fed moves, gingerly, towards policy normalisation.