Implications of ECB and Fed December decisions

The last time the European Central Bank (ECB) and the US Federal Reserve made interest rate decisions in October, the euro to dollar exchange rate declined 425 pips in a single week. If last October is any indicator of the combined effect that an announcement of the ECB and the Fed can have on their respective currencies, investors can expect the month of December to be equally dramatic. The value of the dollar and the euro may be on the verge of some significant changes.

 

On December 3^rd, the ECB is expected to make an announcement on its monetary policy,    followed shortly thereafter by the Federal Reserve on December 16^th. In the run up to these meetings, both the Fed and the ECB have sent strong signals to the market suggesting changes in their monetary policies will take place.  Over 70% of futures traders believe that the US will change its interest rate policy in December. This expectation has slowly been driving the value of the dollar up higher ahead of the meeting.

 

The reason behind the high levels of anticipation for these monetary policy announcements is associated to the effect that quantitative easing, or when governments increase the money supply, have on the value of a currency.  Economic fundamentals demonstrate that when the money supply of a market increases, the value of that currency decreases. The inverse is true when central banks implement tightening policies. Given that the Federal Reserve and the ECB are likely to make changes to their monetary policy, traders can expect to see subsequent changes to their respective currencies.

 

In October’s announcement ECB President Mario Draghi did not change the interest rate or add any new stimulus, though he did signal that further easing was an option for the December 3^rd announcement, possibly taking the form of a deposit rate cut. 

 

Similarly, the US’s decision in October left the interest rate at record lows of 0 % to 0.25%. However, there could be serious consequences for the US economy if the interest rate is maintained at the low levels established in December 2008. For one, the Federal Reserve is concerned that unnecessarily maintaining a loose monetary policy could have an inflationary effect on the market. Moreover, the intention of the Fed’s quantitative easing was to improve the US’ economic performance. This strategy has largely proved successful as Trade24’s chief analyst David Becker noted in a recent analysis of the market. “Important indicators of the US’ economy, including the employment rate, have been robust. As such, the US’s economic conditions, coupled with earlier signals sent by Federal Reserve officials, suggest that a decrease in interest rates is a likely outcome of the December meeting. However, it should be noted that the Fed is unlikely to change the interest rate drastically and instead we can expect to see federal funds rate increase by a quarter of a percentage point at the most. Too drastic a response by the Federal Reserve on the other hand, could undercut the economic growth achieved through earlier policies of quantitative easing. “

 

Since a lowering of interest rates is likely to increase the value of the dollar, and the inverse is likely to occur in the case of the European Central bank, what can we expect the compounded effect of diverging monetary policies between the US and the EU to be? 

 

As the euro declines in value and the dollar increases in value, some expect that the joint effect of December’s events could result in parity between the two currencies.

Recent valuation patterns between the euro and dollar exchange rate suggest that this is indeed a possibility.

 

In the last three weeks the euro has broken two critical benchmarks, falling below $1.10 dollar and then the $1.06 benchmark shortly there after. In the last month alone, the euro has fallen 7.4 % compared to the dollar – and this change has occurred without the added pressure of announcements from either the Fed or the ECB.

 

Whether or not the two currencies reach parity, however, will depend on a number of factors. In either case, investors can expect that if the leadership of Europe’s Central Bank and the Federal Reserve ease an tighten their monetary policy respectively, a US dollar bull market is likely to follow suit.