Thursday, September 4, 2014

Euro weakens as ECB reduces interest rates

The Financial Times has an article on the recent moves by the European Central Bank to stimulate the domestic economy, 

“The ECB is the first central bank to announce large-scale asset purchases and negative deposit rates. The euro could weaken further if European banks use the cash to purchase assets abroad via euro-funded carry trades.”

As a result, the euro fell below  $1.3 and is down almost 5 per cent against the dollar since the beginning of July.

The WSJ chimed in with the graphic above that better illustrates the ECB strategy:  they are buying bonds issued by Eurozone banks, and then charging them 0.2% interest unless the banks lend the euros out.  

If as the Financial Times article suggests, the Eurozone banks make loans to foreign investors, the Euros will weaken by the "carry trade."  Here's how:  A US investor, for example, would borrow from Eurozone banks, sell the borrowed euro's to buy dollars, and then invest the dollars in the US.  This represents an increase in the supply of euros (or the demand for dollars) in the market for foreign exchange.  

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