ECB raises key interest rate for the first time in 11 years: what’s next for EUR vs the USD
European Central Bank (ECB) raised its key interest rate by 0.5% (from -0.5% to 0.00%) – a first rate hike in 11 years. This expectedly, as we published before, pushed the EUR up against the dollar.
The question is what happens next?
Well, key euro interest rate of 0.00%, despite the 0.5% rate hike today, is still very low if we compare it with dollar’s key interest rate (called federal funds rate) of 1.75%. A reminder that Federal Reserve(Fed) raised the dollar key interest rate by 0.75% in their last meeting on the 14-15 th of June from 1% to the current 1.75%.
Why is this important? The key interest rate essentially determines the risk-free return of holding your cash in respective currency in the bank account. So very roughly speaking, if you were to deposit euros into a savings account, your annual payout on those savings would be close to 0.
Whereas, if you were to do that with US dollars, your annual payout would be in the ballpark of 1.75% on the dollars you deposited. This creates greater demand among investors to hold dollars, so investors buy more dollars, sell other currencies, including the euro, which in turn strengthens the dollar and weakens the euro.
So what’s going to happen to EUR against the USD in the short term? The next Fed’s meeting is on the 26-27 of July, where they are expected to further raise the dollar key interest rate by 0.5-0.75%, which would increase the overall rate to 2.25-2.5%. What’s the likely response going to be? Selling of more euros and buying more dollars. These parallel rate hikes by different central banks are often called interest rates wars, as banks try to shore up their currencies to attract capital. So in the short term, we expected a stronger dollar and weaker euro.
The currency value is of course not only affected by interest rates. There are other factors, such as overall currency supply in circulation, but interest rates have a significant impact on the currency value, so until the euro catches up it’s hard to see the path forward for a strong euro.
*The opinion expressed in this article does not constitute a trading advice and is of the author alone.