No Free Lunch

Since the 1979 introduction of the European Currency Unit, or ECU, through its replacement with the introduction of the Euro to present, the average foreign exchange rate of the prevailing European currency against the US Dollar is $1.17.

If a banker woke up after a several-decade coma, they could be forgiven if they looked at the present value (about 1.16 EUR/USD as of the time of writing) and wondered what the big deal was. Moreover, out of the thirty-six combined years, it has declined more than 10% year/year in twenty of them. Milton Friedman, who argued that foreign exchange volatility would find equilibrium and moderate, would find no surprise in the present rate being so close to the opening price of the EUR/USD (1.1591). What he might have found surprising instead was the path that it took to get there.

Why was the Euro worth $1.57 in late 2008, and only $1.16 now? What causes these large fluctuations?

Getting Real (rates)

There are three main reasons for purchasing foreign currency: to purchase goods sold in that currency, purchase securities with a higher expected yield than you can achieve in domestic currency denominated markets, or to speculate on the trade and investment flows from the former pair.

Interest rates are largely a function of a nation’s inflation rates. If an American were to purchase Euro denominated bond yield to try and earn a higher yield, at maturity he would have the opportunity to either purchase goods for consumption in Euros, or convert them back to US Dollars. If prices in Europe had risen faster than in the US, the bond would have needed to at least return more than the relative change in prices for the investor to have returned more (an increase in global purchasing power) than had he invested in US bonds.

No Free Lunch

It’s important to introduce the concept of the no-arbitrage condition here; the alternative name for this is the no free lunch rule. The presumption is that, because investors can simultaneously bet on the future exchange rate, interest rates and price levels between the Euro and US Dollar, the information on those expectations are efficiently priced into the EUR/USD spot rate. The "no free lunch rule" is officially known as the uncovered interest rate parity condition when applied to foreign exchange markets. If this all holds true, the change in EUR/USD should look a great deal like the difference in real (inflation adjusted) rates between the currencies.

From Figure 2 we can see it does. We conclude that the change in exchange rate is largely a function of the relative change in expected purchasing power after being paid interest. In short, the value of a currency is based on what you can expect to consume in it after earning savings in it.

Now that we have a framework for understanding, we can return to the question: why was the Euro worth $1.57? For that, we have to look at the interest and inflation rates between the two economies up until that point in Figure 3.

The cumulative inflation from 1996 to present was 12% higher in the US and at the same time interest rates were 2% higher than in the Eurozone. This led us to the supposition that a Euro deposit would result in higher real purchasing power. From the chart above, we note that Eurozone inflation (Blue) has been lower and Eurozone interest rates higher (Green) for the majority of the time since.

Fast forward to today: EUR/USD is down 15% year/year. US interest rates are presumed to begin a tightening cycle this year, while the Euro area, still mired in deflation, is very much in a loosening cycle. The Euro overnight rate isn’t likely to go up for years, and the European Central Bank (ECB) has brought out new Quantitative Easing measures, which serve to lower long-term interest rates. The nominal rate difference is growing in the favor of the US Dollar. But the astute reader may point out: will the real rate difference grow as well? It’s wonderful to get a higher return, but only if you can actually purchase more real goods & services with it in the future. That’s the critical question which has been driving the EUR/USD to date. Most think that the real rates will diverge further as evidenced by the massive decline in inflation expectations of US Inflation-indexed bonds. Figure 4 highlights the relationship between US inflation expectations (Blue) and the EUR/USD exchange rate (Orange).

The descent of the Euro can be summed up by the following; the steep expectation for rates to rise in the US (but not Europe) combined with strongly declining US inflation expectations are the reasons that deposits in US Dollars will return higher purchasing power than those in Euros.

As that trend goes or reverses so will the EUR/USD rate. In later newsletters, we will explore the main drivers of inflation.