Euro to Weaken as the ECB Pushes Rate Cuts ForwardCME: Euro FX ( CME:6E1! )
On June 6th, the Governing Council of the European Central Bank (ECB) cut the official Interest Rate on the Deposit Facility by 25 basis points from 4.00% to 3.75%. This was the first ECB key rate reduction in five years, signaling a major shift in monetary policies in the 20-nation Euro Zone.
The ECB rate decision was widely anticipated and has already been priced in the financial markets. On June 7th, the Euro-USD exchange rate was unchanged at $1.080 per Euro. The US Dollar Index edged up 0.83 points to settled at 104.94.
In my opinion, the ramifications of ECB rate cuts are underappreciated. This significant event marks the policy divergence between the ECB and the U.S. Federal Reserve. Their differing rate trajectories could lead to the Euro weakening against the Dollar.
How are Exchange Rates determined?
In economics, Interest Rate Parity (IRP) states that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. The formula for IRP is:
F0=S0 × ((1+ ic)/(1+ib)) , where:
F0 = Forward Rate, S0=Spot Rate;
ic = Interest rate in country c; ib = Interest rate in country b
In the IRP formula, “b” stands for base currency where "c" is the currency to quote. As Euro-USD exchange rate is expressed as number of Euro per 1 Dollar, i(b) is US interest rate, where i(c) is ECB interest rate.
Let’s examine a hypothetical situation where the ECB cuts interest rates three times but the Fed only implements one cut. All rate cuts are in the 25bp increments.
Inputs: The ECB cut rates from 4.00% to 3.25% (new ic), and the Fed Funds rate will be lowered to 5.25% (new ib) from 5.50%. Before the cuts, the Euro/USD spot rate was 1.0800 (S0).
Output: Plugging the data into the IRP formula, we get a forward rate of 1.0595 (F0), which is computed as 1.800 x (1.0325/1.0525).
The IRP suggests that the Euro exchange rate would be lowered by 205 pips, or 1.9%, if the above assumptions hold true, all else being equals.
This calculation is remarkedly simple, but nonetheless it describes what drives the value of any currency going up or down. Let’s explain this in plain English:
An investor has the option of investing in either U.S. dollar or Euro. The market currently expects the ECB to lower rates more frequently than the Fed would, resulting in the interest rate spread between the dollar and the euro widening in the coming months. As a result, dollar assets would produce a higher return relative to the euro.
In the currency market, arbitrageurs will buy up the dollar and dump the euro and attempt to lock in a return generated by the interest rate spread. This would result in the euro depreciating against the dollar. An equilibrium in Euro-USD exchange rate will be reached where holding assets by either currency generates the same return. This is the logic behind the IRP. It is called the Law of One Price.
Many factors impact exchange rates. A framework using the IRP is a simplified but very insightful approach to project exchange rate movement over the medium- to long-term. Other factors, including but not limited to inflation, employment, consumer spending and corporate profit, can be viewed as variables influencing the central bank rate decisions.
Asides from the mathematical approach, we could consider a country’s currency being reflective of its economic strength. In the early 2000s, the European Union (EU) grew at a faster pace than the US in terms of Gross Domestic Product (GDP).
• Between 2000 and 2007, US GDP grew 41.2%, from $10.25 to $14.47 trillion.
• Meanwhile, EU GDP nearly doubled, growing 98.8%, from $7.28 to $14.73 trillion.
• The EU economy grew from about 2/3 of the US to matching to the same size.
• Backed by a strong economy, the Euro gained in value, from 90 cents to over $1.50.
However, the trend has been reversed in recent years.
• In 2023, US GDP grew to $27.36 trillion, up 167% from 2000, where EU was up 152% to $18.35 trillion. The size of the EU economy is now down to 67% of the US economy.
• Since peaking at $1.22 in December 2020, the Euro has been in a multi-year decline, currently trading at around $1.08.
More recently, the EU has been hit hard by the global pandemic and geopolitical conflict. Its economy slows and unemployment rises, while inflation becomes sticky. Compared to the Fed, the ECB has more urgency to lower rates and provide relief to the economy of its member nations.
When examining the long history of the ECB rate setting behavior, I find its preference in ultra-low rates. In fact, the ECB maintained a negative key rate (-0.5%) for years, before being forced to align with the Fed in a rate-hike journey to fight high inflation.
Another observation: The Fed is an independent central bank and has the power to set monetary policy independently. Neither the President nor the Congress could exercise direct influence on the Fed interest rate decisions.
The ECB, on the other hand, gets tremendous pressure from political leaders in the 20 governments within the Euro Zone. Rate cuts appeal to both political demand and public sentiment. Therefore, low rates will be a comfort zone for the ECB to fall back into.
Unrealistic Market Expectations on the Fed
This morning before US market open, the Bureau of Labor Statistics reported that the US consumer price index was unchanged for the month of May, lower than the 0.1% market estimate. On an annualized basis, the US CPI increased 3.3%, which also came in below expectations and represented a slowing from the prior 3.4% pace.
Investors cheer for this good news. The three major US stock indexes jumped between 1%-2% in mid-morning. The 10-Year US Treasury Yield slid 140 bps to 4.264%.
The Fed will release its June FOMC rate decision at 1:00pm, followed by a speech by the Fed Chair. The market currently expect no rate change in June, but the consensus is moving towards to 2 rate-cuts from 1 rate-cut by the end of the year.
While the global markets would react strongly in the short term to any hint the Fed gives out on future rate trajectory today, the dust will settle once investors calm down. I still hold the opinion that the Fed is in no hurry to cut rates with inflation above 3%. The US economy is on solid ground. Cutting rates too soon would jeopardize the hard work of combating the out-of-control inflation in the past two years.
Trading with CME Euro-FX Futures
A short position in CME Euro-FX futures (6E) is a way to express this bearish view on Euro.
The September (6EU4) contract is quoted at 1.08605 on June 12th. Each contract has a notional value of €125,000. CME requires an initial margin of $2,100.
For a short futures position, a decline (increase) of 1 pip (0.0001%) in the exchange rate will result in $12.50 in gain (loss) in your account balance.
Our earlier example suggests that the Euro-USD spot rate could be lowered to 1.0595, if the ECB pushes rate cuts forward. For illustration purpose, if 6EU4 price drops to 1.0595, the price change will be 265.5 pips (1.08605-1.0595=0.02655). And the gain in the short futures account would be $3,318.75 (= 265.5 x 12.50).
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
