Home > US and European Monetary Policies Divergences Disappeared

US and European Monetary Policies Divergences Disappeared

Currency traders know that one of the main volatility drivers for the FX market is the monetary policy set by central banks around the world. 

Changes in the monetary policy in one part of the world create flows responsible for the movement in given currency pairs.

Since the start of the coronavirus health crisis, central banks have rushed to ease monetary policy conditions. Not that they were excessively tightened before, but the need came for further easing rose.

If in the case of the Fed, the decisions were somehow expected (e.g., quickly cutting the federal funds rate close to zero), many investors wondered how the ECB would manage to ease further, considering that it had the rates close to zero even before the pandemic?

ECB’s TLTROs Made Up the Difference

While it was difficult to imagine what the ECB may do to make up the difference with the Fed easing, the TLTROs solved the problem. More precisely, the ECB offered the Targeted Long Term Refinancing Operations (TLTROs) at negative rates and banks hurried to pick the loans up.

With a stroke of a pen, the ECB flooded the market with Euros as commercial banks already started to deploy the newly created funds to the economy, both to businesses and population.

After the surge in TLTRO volumes, the ECB’s balance sheet increase since the start of 2020 is on par with the Fed’s. In other words, the ECB played catch-up with the Fed, and now the two major central banks stand on equal food.

Naturally, one cannot wonder if this is not the reason why the EURUSD pair, which reflects the two central banks’ monetary policies, corrected from 1.14 to the recent 1.12. Right after the pandemic started, the Fed was quicker to ease – so the USD fell, while EURUSD rose. The pair rose from 1.08 to 1.14 in a couple of months, squeezing many short-sellers.

Now that the market realizes that the ECB eased as much as the Fed, and perhaps even more (Europe has a much more bank-based financial system), will we see the EURUSD back to 1.08?

If yes, it is yet another proof that monetary policy and the value of a currency work hand in hand.

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