The currency markets can be very complicated, and there are many theories explaining how and why they move.
One of the more basic theories is interest rate parity, which argues that fluctuations between two currencies can be explained by interest rate differentials. The idea is that if one country offers a better interest rate than another, a trader would convert currencies and buy bonds at the higher rate. But what would seem like a guaranteed profit for the trader would be offset by a move in the foreign exchange rate.
In recent years, the moves between the euro and U.S. dollar appeared to reflect interest rate differentials.
But in more recent months, that relationship has decoupled.
Morgan Stanley’s Hans Redekar explains:
Concerning the performance of the EUR, we have to differentiate between noise and trends. At this stage, it is the flow into the eurozone equity markets and eurozone banks reducing the size of their balance sheets, which are driving EUR, and not the relative growth trend or even interest rate differential. The chart below illustrates the de-coupling of EURUSD from rate differentials, bearing a very clear message.
During the week ending October 23, investors plowed $US5 billion into European equity funds, the biggest weekly inflow ever.
“These funds have seen nothing but inflows for the past 17 weeks,” reported BI’s Matthew Boesler.
“Only when banks have prepared balance sheets well enough for the [Asset Quality Review] does the EUR have the potential to fall back to ‘fair’ levels defined by yield and interest rate differentials,” added Redekar. “Since the AQR will reference 2013 year-end balance sheets, we think the EUR is likely to peak in early to mid-December.”
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