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Hawkish to Dovish: The ECB and the Tumbling Euro

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Monetary policy turns from hawkish to dovish

In mid-2008, the ECB (European Central Bank) raised the interest rate to 4.25%, keeping a hawkish stance to control mounting inflation pressures. However, with the onset of the economic turmoil, the central bank cut interest rates to a record low of 0.05% in September 2014, while deposit rates entered negative territory.

The euro tumbled against the US dollar as speculations increased of a breakup in the common currency caused by severe debt burdens and huge differences in the economic strength of its member countries.

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ECB entered into quantitative easing

As low interest rates and negative deposit rates weren’t able to raise the inflation outlook, the ECB introduced a monetary stimulus program. Prior to its release, the SNB (Swiss National Bank) removed the peg of the Swiss franc with the euro to protect itself from the huge depreciation of the euro after the announcement of the QE (quantitative easing) program.

The program was announced in January 2015 to buy assets worth 60 billion euros every month until September 2016, causing the value of the euro to drop considerably to 1.1 levels. However, with a depreciated currency, European exporters were able to benefit from higher margins and provide a boost to manufacturing and industrial production in member nations.

The iShares MSCI Germany ETF (EWG) and the WisdomTree Europe Hedged Equity ETF (HEDJ) have declined considerably since the introduction of the QE program by the ECB. So have with European ADRs (American depositary receipts) such as Alcatel-Lucent (ALU), Banco Bilbao Vizcaya Argentaria (BBVA), and ING Groep (ING).

Divergence in US and European monetary policies

While the ECB was taking its dovish stance on monetary policy and keeping a massive QE program going to increase inflation levels, the U.S. Federal Reserve ended its QE program and shifted toward a policy to hike the benchmark rate. The Fed raised interest rates from 0.25% to 0.50% in December 2015. This led to an increase in the US Dollar Index, which calculates the strength of the US dollar versus a basket of currencies, including the euro.

In the next part, we’ll see how the slowdown in China and devaluation of the yuan has affected the Eurozone and the euro.

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