5.3 Market Reactions to Central Banks - FOMC Example

We will attempt to show how important interest rates are to currency movements by examining price action on the Forex market during a recent central bank tightening campaign. The following example focuses on the EUR/USD pair.

Let’s investigate the implication of the United States Federal Reserve’s interest rate decisions to the value of the US Dollar.

Dollar Gaining

The Euro started 2005 at a high exchange rate, 1.3500 Dollars per Euro. US interest rates had been hovering at very low rate of 1% prior to this time and the Euro was appreciating. In 2005, on the other hand, there was steady Euro depreciation. The US central bank, the Federal Reserve, continued a campaign, started in July 2005 to gradually raise interest rates from 1%. At every subsequent meeting of the Federal Open Market Committee (FOMC), federal officials increased the base interest rate by .25%. Financial markets reacted to this gradual hiking campaign by favoring and strength ending the Dollar. When 2006 started, the EUR/USD pair traded around 1.2000, a change of 13 cents or 1300 pips. The central bank's actions were a major cause for the Dollar appreciating in 2005.

Trend Reverses

In December ‘05, at the 1.2000 level, the Euro finds support and begins to gain (second rectangle). At this time investors are speculating that the Fed tightening campaign is likely coming to an end. Similar speculation, and Euro appreciation, happened between July and August ‘05 (first rectangle). In February the Fed’s base rate was raised to 4.50%. Speculation that the Federal Reserve would finally pause after 15 straight rate hikes continued throughout March and the first half of April, creating an upward trend favoring the Euro.