2 graphs on how the Fed is helping the Euro Area

Fed’s decision on Wednesday to keep a strict monetary policy will help the euro area. It will extend the monetary policy divergence between the Fed and the ECB and this will drive down the European currency.
Since last summer, that’s what was observed. A very accommodative and credible monetary policy for an extended period on the ECB side and an expected change on Fed’s side circa summer 2015. (before of after the summer 2015 is not important here). This divergence led to a lower euro.
Things changed on October the 15th. Gloomy expectations on the world economy have suggested that the Fed could postpone the change in its monetary policy. US short-term forward rates went down rapidly and the Euro depreciation stopped immediately. The shock was temporary but strong (we remember that during  that day the 10 year TBond rate dropped almost to 1.8%).
The Fed’s perception of the US economy in the press release following its last FOMC meeting (October 28) changed investors’ mind again. The Fed will hike its interest rates around summer 2015. No change from what was read before; the press release was even a little more hawkish.
Short term forward rates were up again and the soft recovery has accelerated after the FOMC meeting.
The divergence between ECB and Fed monetary policies is back on track. The Euro will continue to depreciate. This will be positive for growth (improved competitiveness for Euro area exports) and this will reduce the risk of deflation as the Euro area will import inflation.

The two charts below show the mechanism
The first chart shows the spread between monetary policies expectations (blue line). It is the difference between 2 year rate in 1 year. The purple line is the euro dollar exchange rate. Since last summer, euro was trending downward until October the 15th.
We see that recently the situation has changed dramatically. This is the part in the red circle. Now the euro exchange rate is back to 1.253.
paritaux-en-31octoberThe second chart shows the 2 components of the blue line in the first graph. We see a divergence since the beginning of the year between the two curves. In the red circle we see the rapid narrowing and then the divergence again. The first movement led to a stop in the euro depreciation, the second to a convergence to the previous path. Euro will continue to depreciate
paritaux-en-31october-expect

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