Introduction
The Federal Reserve has ended its quantitative easing program, and interest rates are expected to rise in the second half of 2015. Meanwhile, Mario Draghi and the European Central Bank (ECB) recently received legal approval to implement a large quantitative easing program across Euro-denominated European countries, and they will soon commence a bond buying program at a rate of 60 billion euros per month. Overall, the Euro (EUR) will continue to plummet in value against the U.S. Dollar (USD).
Chart of EUR/USD Exchange Rate
Source: Google Finance
In the first half of 2014, the Euro's peak valuation was at 1 EUR = 1.39 USD, and this exchange rate has fallen dramatically to 1 EUR = 1.1206 USD.
Increasing Foreign Demand for the U.S. Dollar
The USD is considered the reserve currency of the world. A USD reserve currency implies a few key characteristics: governments and foreigners hold vast quantities of the USD; oil transactions and other large monetary transactions use the USD currency; and the USD is considered to be a safe-haven asset in the world.
Because the USD is the global reserve currency, it is estimated by Harvard University Professor Kenneth Rogoff that America saves over $100 billion in borrowing and interest rate costs.
As economic volatility and inflation impacts Russia, Venezuela, Brazil, and other major countries, the demand for the USD will rapidly increase as investors and governments transition to holding more safe-haven assets. Affluent Chinese investors and businesspeople have a growing demand for their assets to be converted to USD-dominated assets in order to protect themselves from government asset seizures and potential fears of the Chinese currency moving towards a floating exchange rate. In addition, Chinese and other foreign governments have been rapidly buying U.S. government debt, which allows them to earn USD-denominated income from a safe asset.
Recent Swiss Monetary Action
Recently, Switzerland drastically changed its monetary policy and no longer created a maximum value ceiling for the Swiss franc against the Euro. Essentially, Switzerland has ended its partial sterilization of its exchange rate. This has caused the Swiss franc to swiftly appreciate in value against the Euro and will cause Swiss exports (particularly Swiss exports of luxury products) to decline in Europe.
The Impossible Trinity
Basic macroeconomic theory regarding exchange rates states that out of the "impossible trinity", a central bank can only achieve two of the three traits in the trinity. The traits of the impossible trinity include a fixed exchange rate, independent monetary policy, and free capital mobility. Both America and the Eurozone have independent monetary policy and free capital mobility, but the value of the USD and Euro floats on the currency market and therefore, the value of the currency depends on the fundamental economic principles of supply and demand. Therefore, market participants can easily short sell the Euro against the U.S. Dollar.
Macroeconomic Theory & Exchange Rate Models
(Note: The ideas from this section were heavily borrowed from Frederick Mishkin's Macroeconomics: Policy and Practice textbook and Paul Krugman's Exchange Rate Instability)
The real exchange rate is given by the formula:
The real exchange rate represents the relative price of goods and services across two countries; essentially, the real exchange rate is the rate at which a market participant can exchange domestic goods for foreign goods. The real exchange rate differs from the nominal exchange rate, which represents the relative price of one currency in terms of another currency.
Under the assumption of covered interest parity, the exchange rate is an approximate function of interest rate differentials between two currencies and the expected exchange rate. To calculate an approximate of the future EUR/USD exchange rate, I have used the following variables (numerical values as of 1/23/15):
As the spread between the U.S. 10-Year Treasury yield and average Eurozone 10-Year government bond yield widens, the Euro will continue to fall in value against the U.S. Dollar. This spread increase is a real and legitimate occurrence; the ECB's newly-announced quantitative easing program will drive down Eurozone interest rates, while the Federal Reserve's end of quantitative easing and subsequent rise in U.S. interest rates in late 2015.
Furthermore, connecting exchange rate theory with macroeconomics, an exogenous depreciation of the Euro against the U.S. Dollar through an ECB QE program will create an increase in aggregate demand through increased net exports and consumer spending, but a depreciating Euro would also lead to a negative aggregate supply shock due to a higher Eurozone price level. Fundamentally, a depreciating Euro will stimulate both GDP and the inflation rate, and this is also visually depicted in the graph below.
Source: Mishkin, Macroeconomics: Policy and Practice textbook
Effect of ECB's QE Program
Mario Draghi is the President of the European Central Bank and recently announced the implementation of a quantitative easing program that is similar to America's and Japan's. The ECB QE program entails a bond buying program at a rate of 60 billion euros per month in hopes of further lowering interest rates, providing liquidity to financial markets, and providing banks and other financial institutions the necessary capital to start lending and growing their businesses.
Interestingly, a key similarity exists between ECB President Mario Draghi and former Fed Chairman Ben Bernanke: both economists were mentored by Stanley Fisher at MIT, and both implemented (or in Draghi's case, will implement) a quantitative easing program in hopes of having a hugely expansionary monetary policy to stimulate the European economy.
Allocation of capital purchases of the ECB QE program on different countries will be interesting to watch, especially since different European countries have different growth rates, and Germany currently being the only. Despite a few flaws of the Federal Reserve's QE program in America (increase of income inequality, destruction of repo market, essentially a bank recapitalization, junk debt bubble), the pros far outweigh the cons because America recovered at a much faster rate than the rest of the world after the 2008 financial and housing crises. In theory, the ECB's QE program should eliminate fears of deflation and continue to supply capital to financial markets in hopes of stimulating the Eurozone economy. I hope the ECB QE program is equally successful in improving the stagnant state of the European economy and provide positive economic hope in Europe.
Conclusion
The divergence between economic activity and monetary policy continues between America and the Eurozone. America is experiencing strong GDP growth, low unemployment rate, and the end of the quantitative easing program, thereby increasing interest rates in the second half of 2015. Meanwhile, Europe has experienced stagnant growth through austerity programs over the last 7 years, and the ECB will now implement its version of a quantitative easing program to stimulate the economy and eliminate fears of deflation. One concern that may arise from ECB quantitative easing is a liquidity trap, in which interest rates face a zero-bound. By applying macroeconomic models and exchange rate theory onto current events regarding the EUR/USD exchange rate, one can easily conclude that the Euro will suffer a massive devaluation in value against the U.S. Dollar.
