Stretching the Euro

Selling Too Soon

One thing we have learned in the three decades of flexible exchange rates is that official actions in the form of massive fiscal and monetary policy changes can end one-way trades. These episodes often are accompanied by large corresponding adjustments in bond markets, as is required by the mathematics of covered interest arbitrage.

Should Europe start to feel the pain of a too-strong currency, its only possible solution will be to lower its interest rates to match the policies of the U.S. That may remove the various intervention bids from the dollar and lead to an upward adjustment in U.S. interest rates, a scenario that could pose significant risks to U.S. financial markets later in the year.