Many financial commentators argue that the difference between European and US interest rates fails to explain the soaring euro exchange rate vs. the US dollar. That’s because they are looking at the wrong interest rates. European government yields are artificially low because the European Central Bank continues to buy vast amounts of government bonds, EUR 60 billion a month during 2017 and EUR 30 billion a month starting in 2018. But the yields that banks and corporations actually pay to hedge interest rates, the swap rate, have risen faster than government yields in Europe.
The difference between US and European government bonds is not particularly important for the currency market. More important is the actual cost of hedging future rates in both markets.
The difference between short-term and medium-term swap yields is a good gauge of where investors think interest rates will be in the future. To hedge against rising rates, investors will enter a swap agreement in which they pay the 5-year yield and receive the 6-month yield. That has the same effect as shorting a cash bond in order to hedge against rising future rates. If the preponderance of demand is to short rates, supply and demand will push up swap yields faster than government yields.
The data below are from Jan. 1, 2017 to the present. The slope of the swaps curve in EUR and USD respectively explains EUR/USD very well. The regression fit of EUR vs the two slopes is 92%, and is robust (no problem with serial correlation, no trend variable, etc.).
This simply tells us:
1) The expected interest rate differential, not the present interest rate differential, drives the exchange rate; and
2) The actual cost of taking balance sheet positions in EUR vs. USD (which reflects the swap rate) rather than sovereign yields is important.