Stretching the Euro

One consequence of the financial aspect of currency trading is that any exchange rate can take on any spot market value and still clear the market; all traders need to do is hedge themselves appropriately in the interest rate markets. If exchange rates had no other macroeconomic effects, this would be harmless child's play, but exchange rates have significant effects throughout all sectors of an economy. The recent weakness of the dollar, for example, is penalizing importers and rewarding exporters, and is creating greater pressures to tighten credit than would exist otherwise.

The Dollar-Euro Rate Gap

I noted last week how the euro was continuing to strengthen even as the rate gap at six months had ceased moving in its favor, and even as the overnight futures markets in the two currencies were signaling expectations for higher dollar (USD) rates relative to euro (EUR) rates. The same conclusion can be reached by examining the rate gap across the money market curve.

Rate Gap Closing More at Longer Horizon

Source: Bloomberg

The rate gap, defined here as the absolute USD-EUR spread divided by the USD rate, was at its widest all the way back in November 2002. Not only has it been closing steadily in favor of the dollar since then, but the gap is becoming narrower at the longer maturities of the money market curve. This same pattern is continued in the bond curve to the point where 10-year USD now yields more than 10-year EUR.

Rate Gap Closed at 10 Years

Source: Bloomberg

Inflation Gap

This behavior makes sense only if the market is expecting a higher rate of inflation in the U.S. than in Europe, and for higher American inflation to persist over time. Restated, currency traders are bidding the dollar down to compensate for a higher inflation component within these nominal rates. While there are no euro bonds directly comparable to TIPS, we can examine some short-term clues on relative inflation. The year-over-year changes in consumer price inflation were more rapid in the U.S. than in Europe between mid-2003 and early 2003, but that trend has reversed of late.