Looking at Interest Rates Through the FX Lens

In today’s blog, we’ll look at the historical economic development of the EU and the US, how they’re interconnected, and how decisions from one central bank might have far-reaching effects on the other. All with the aim of understanding the interest rate environment, and how it might develop.

ECB’s latest decision to decrease the key deposit interest rate by 0.25 bps to 3.75% has long been expected by the market, both in Europe but also the US. The Bank’s leadership decision to “signal” a rate cut instead of taking a more careful path as their colleagues in the US of “being data dependent” has put significant pressure on the ECB to follow through, which they did recently. However, besides economic indicators affecting the European countries themselves, several other indicators or clues often get left behind.

One of the primary ones is for sure the strength of the foreign exchange rate of the Euro, especially as compared to the dollar. To understand this dynamic, we have to delve a bit deeper. EU as a Union, and especially its largest constituents are quite export-orientated. Since the end of the Cold War and the proliferation of globalization, the US has often been cited as one of the primary benefactors, allowing them to extend their influence across the world, while at the same time acting as the “world police”. Developing countries, especially China, Japan, South Korea, and other Asian tigers are also often cited as managing extreme growth exactly due to globalization, and how said globalization allowed them to almost completely reengineer their economies on an export basis.

Europe on the other hand, has always been seen as an old continent. While being a continent of economic leaders for centuries before being overtaken by the US, many European countries that were ruined during WW2 found a new place exactly through similar means as the Asian countries – in exports. One caveat here is that the goods produced on the old continent were of higher-added value, be it cars, machines, or luxury goods. However, it was only truly after the end of the Cold War and the establishment of the EU that the continent found its true footing.  

One of the most important developments coming from this process was the introduction of the euro, a new currency that would bring the European countries even closer together. While the euro has from the beginning been designed to be a stronger currency as compared to the dollar, which the exchange rates clearly indicate, in this blog, we are more interested in their dynamics following the Global Financial Crisis of 2008.

USD/EUR exchange rate (2008 – 2024 YTD)

Source: Bloomberg, InterCapital Research

As we can see from the graph, 1 dollar was equivalent to 0.68 euros in 2008, or rather, the euro was “32% stronger”. While a weaker currency benefits exports, as it makes them less expensive (just take the example of China and what they did to their own currency), the stronger position of the euro actually benefited Europe for years, with the export of less quantity, but higher quality and price goods being the norm on the continent. One only has to look at Germany, France, or Italy and the plethora of sectors and brands in which these countries are global leaders.

Why is this important for our story? Because of its interdependence with economic growth as well as the perceived strength of the currency, both of which have a huge influence on interest rates deployed by Central Banks.

EU and US GDP growth rate (Q1 2008 – Q1 2024, quarterly, YoY, %)

Source: Eurostat, InterCapital Research

While for many years EU and the US were neck in neck in terms of GDP, after the crisis of 2008 the US started to pull farther and farther away from the EU. Brexit did not help this either, but even excluding Britain, the growth in the EU has been rather stagnant for the last couple of years. In fact, since 2008, the EU grew by just 1.03% on average, while the US grew by almost 1.9%. A lot of reasons could be named for this discrepancy, including lower investments in the EU, more stringent regulation, an overblown bureaucracy, and lower productivity, among many other things. However, here we will rather focus on what effect this stagnation has on ECB’s decision-making.

Since the beginning of COVID-19, the subsequent slowdowns in economic growth, followed by money printing to the Moon (quantitative easing), supply chain disruptions, inflation, and finally the War in Ukraine and the subsequent further fuel on the inflation fire, central banks around the world scrambled to do what they can to avoid a crash, ECB included. However, compared to the US for example, Europe’s inflation, and subsequently interest rate hikes were driven by different factors. While elevated energy costs affected the US as well, it was not as harsh as in Europe. As such, much of the inflation in the US was labour driven, as following COVID-19 and strong inflation many workers were demanding higher salaries, fueling inflation. While this occurred to a lesser extent in Europe, the primary driver of inflation here was the energy prices, as Europe and especially countries such as Germany, Austria, Hungary, etc. were extremely dependent on cheap Russian gas.

This is important because it meant that when the ECB was making interest rate-related decisions, they were facing different circumstances than the Fed, and thus could be influenced differently. While both central banks boosted interest rates significantly in the last couple of years, it was the ECB that provided the first reduction, and only recently.

ECB and Fed key deposit interest rates (Q1 2008 – Q2 2024, %)*

Source: ECB, Fed, InterCapital Research

*Not all key interest rates are shown, only the ending values at each quarter

Following this reduction, the dollar slightly increased in value as compared to the euro. Taking all of this into account, we might see the conundrum that the ECB is currently in. EU economic growth has been slower than the US, leaving less wiggle room. Inflation has been different, and harder to tame, leading to higher interest rate requirements, which are supposed to last for longer. Of course, the ECB’s management backed themselves into a corner by promising a rate cut. Further rate cuts in the future might support economic growth but would lead to lower yields on the euro bonds, and also a weakening of the euro as compared to the dollar. As such, it might seem that besides inflation and economic growth dynamics, the ECB has one other key indicator to look at: the Fed’s decisions on their own rate cuts.

With faster economic growth in the US and more isolation from energy price shocks as compared to Europe however, the Fed has more time to wait, with them recently signaling “only one” rate cut by the end of the year. ECB it seems, cannot afford such a luxury as taking more time, as EU’s largest economies are stagnant, while at the same time, others have issues servicing their debt at these debt levels. As such, it seems that the road ahead offers no clear winners and only challenges.

What could be expected in this environment? Even if the ECB is willing to cut the rates further, they also have to be prudent to not steer too far away from what the Fed is doing. As such, in a sense, Europe right now is a far cry from the continent of world leaders it was but a century ago. But like the wind, times also change, and maybe Europe could change as well.

Mihael Antolić
Category : Blog

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