Reason for the currency markets' extreme stability

In 2023, euro/dollar traded in a range of just over eight cents. 

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Last year euro/dollar traded in a range of just over eight cents, between a low of around 1.0450 to a high of around 1.1275. That’s the second smallest trading range since the euro came into being in 1999 (the lowest being the seven cent range in 2019). And so far this year the stability has continued with just a three-and-a-half cent range to date. The average trading range since EMU started is around eighteen cents so last year’s performance was less than half the usual amount of variation.

Many other currencies have been similarly constrained. The pound traded in a thirteen-and-a-half cent range last year compared to an average of near twenty-two cents since 1999. The only major currency to show more normal levels of variability was the yen, as its twenty-four-and-a-half yen range last year was one of the largest we have seen since 1999 and above the average of around sixteen-and-a-half.

It is perhaps even more notable that the trading range in euro/dollar has been so small when dollar/yen has been so big. This observation provides a clue to both why the yen has been so volatile and the euro so lacking in volatility. It is because differentials in interest rates between the US and Japan have moved quite wildly in recent years while those between the US and the euro zone have been quite stable.

For even though interest rates have risen sharply and quickly, with the Fed lifting the fed funds target by 525-bps, for instance, the ECB, and most other central banks besides the BoJ, have kept pace. Before the tightening cycle began the spread between the fed funds target and the ECB’s main refinancing rate was 25-bps and today it is not significantly higher at 100-bps. When it comes to the UK, the base rate was 25-bps below the Fed’s target rate (the upper bound) and today is still 25-bps below the US rate. If rate differentials really are the key to this stability, then the future looks to be even less volatile for the dollar because the market is pricing in extraordinarily close correlation between the Fed and ECB when it comes to policy easing in 2024. The market sees both starting rate cuts in June and trimming rates by close to 100bps by the end of 2024.

In the end, things might not work out this way but even if one central bank starts a little earlier of later, or cuts by more or less, it seems unlikely that there will be the discrepancy required to produce significant variation in euro/dollar and the same can be said for other currencies (with the probable exception of the yen). So, should we just throw our arms up in the air and assume that euro/dollar is going to flatline as far as the eye can see?

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Mr. Steve Barrow, Head of the Standard Bank G10 Strategy doesn’t think so. If we look back again at recent years, it is notable that euro/dollar was very stable in 2023 and we put much of this down to the limit ed movement in interest rate differentials even though policy was being tightened aggressively by both the Fed and ECB. Go back a year further, to 2022 and euro/dollar saw more than twice the trading range of 2023, at close to twenty-cents and yet rate differentials were quite stable in this year as well. The volatility in 2022 was explained by the hugely negative terms of trade shock that the euro zone experienced from the gas price surge following Russia’s invasion of Ukraine while the subsequent reduction of volatility in 2023 owed much to an unwinding of this terms of trade hit as energy prices fell.

In short, in Mr. Steve Barrow’s view, big variations in currencies often occur as a result of shocks that are unrelated to monetary policy. But while this might open up the prospect of greater euro/dollar variation this year even if central bank policies are locked together, it does seem as if such volatility requires new shocks. Of course, shocks can be totally unanticipated beforehand and we can’t predict these. But others may not be too surprising, or ‘shocking’, such as a Trump victory in November’s election or a military breakthrough on either the Ukrainian or Russian side. In short, there’s enough scope for shocks to occur to make us feel that euro/dollar won’t be as tied down in 2024 as it was in 2023.