What Causes Volatility In The Euro?

Euro Basics

The euro is the official currency of 19 nations. Roughly 339 million people harness the euro on a daily basis, and more than 175 million people across the world use currencies with an exchange rate tied to the euro.

While member nations began using the common currency for accounting purposes in 1999, the citizens of the eurozone did not start trading euro bills and coins until 2002.^[1] By using a common currency, nations, businesses and individuals can derive many benefits.

One such perk is easier cross-border trade. By removing exchange expenses and fluctuating exchange rates, market participants have greater stability and a lower cost of business. The euro makes it easier for travelers to visit the nations that use the currency, and consumers can access a wider range of options because of the aforementioned benefits.

Through the Economic and Monetary Union, the 19 nations of the eurozone can work together to coordinate economic and fiscal policy.^[2] While the EMU includes the 28 nations of the European Union, not all countries in the EU belong to the eurozone.

Euro Volatility

While the common currency may come with numerous benefits, it has encountered some strong volatility in the aftermath of the 2008 financial crisis. Its price fluctuations have garnered a lot of media attention, so there is substantial information available on the factors credited with prompting this volatility.

Global Risk Aversion

The rise and fall in the euro's exchange rate has repeatedly been tied to global risk aversion. When investors are willing to incur risk in exchange for a greater chance of compelling returns, they might opt to purchase the common currency.

Global market participants frequently flock to riskier assets en masse in hopes that doing so will generate strong returns. This phenomenon is known as risk-on trading. In September 2015, for example, the euro hit an eight-month high against the Swiss franc, considered by many to be a safe-haven currency, when global investors flocked to riskier assets.^[3]

The other side of the coin is risk-off trading, which is when investors buy up safe assets because of their desire to protect their principal. An example of this occurred on October 18, 2015, when the common currency fell to its lowest in more than two weeks against the yen, a safe currency, as global investors fled riskier assets.^[4]

It is worth noting that if global investors want to participate in either risk-on or risk-off trading, there are many other ways they can do so besides buying or selling the euro. When traders are confident in economic conditions and want to invest in riskier assets, they purchase emerging market currencies such as the yuan or rupee. Others may opt for another asset class entirely, choosing to buy either equities or commodities such as oil.

Trader Speculation

The speculative activity of traders makes up a large portion of the global forex markets, in which market participants trade more than US$5 trillion in notional value a day.^[5] The euro has generated substantial attention from global investors.

Net euro shorts hit an all-time high in March 2015, according to data provided by the U.S. Commodity Futures Trading Commission and Thomson Reuters.^[6] As a result, net euro shorts rose to more than 200,000 contracts.

ECB Policy

These bets that the currency would fall in value surged to this level as the ECB began a new program of quantitative easing. Pursuant to this initiative, the eurozone's central bank planned to buy US$3 billion worth of bonds every day.^[7] By making these transactions, the financial institution aimed to ignite stagnant economic growth and increase inflation.

One consequence of expanding the money supply was placing downward pressure on the euro. Such a move could help bolster economic conditions of European nations by making goods denominated in the euro cheaper for market participants using other currencies.

The ECB's interest rate policy is another factor that has affected the euro. In June 2014, the financial institution began imposing negative 0.1% rates on deposits it was holding.^[8] During September 2014, the ECB lowered this rate to negative 0.2%.

By cutting interest rates, central banks can help affect the economies of their respective jurisdictions. By pushing the rates below zero, the ECB has aimed to give people greater reason to borrow and less incentive to save. Additionally, the move might motivate banks to offer more money to businesses and consumers at lower interest rates.

Greek Crisis

Greece has been struggling with financial challenges for years. As a result, its continued membership in the eurozone has been brought into question. The nation has requested multiple bailout packages in order to avoiding defaulting on its obligations, and these cash infusions have come in exchange for austerity measures.

The country's parliament approved the 2016 budget in early December 2015, which cuts €5.7 billion from public spending.^[9] In spite of these sharp reductions, which include €500 million from defense and €1.8 billion from pensions, Greece is still forecasting that its 2016 budget deficit will surpass that of 2015.

The euro's value has encountered headwinds when concerns have flared up about Greece leaving the eurozone.^[7]

Fed Policy

The Federal Reserve announced its first interest rate hike on December 16, 2015, declaring that it was increasing its target for the federal funds rate to a range of 0.25% to 0.5% from the previous range of 0.00% to 0.25%.^[10] In addition, the Fed ceased its bond purchases in late 2014.^[11] These two policies contrast sharply with those used by the ECB, which could result in downward pressure being placed on the euro relative to the U.S. dollar.

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