Forget about predicting how the political winds will blow in Italy and Spain, if there are green shoots in the Eurozone economy or anything else you read in the mainstream media. The most important factor driving the exchange rate between the euro and the dollar is the Fed and the ECB balance sheet ratio.
The chart above shows the relationship quite succinctly. Let’s update it to show the direction the rate is heading. A few weeks ago, the all-important ratio was about 1.04 to 1 with a corresponding exchange rate just under $1.35. Eurozone banks managed to repay some of their LTRO loans since then decreasing the ECB’s balance sheet while the Fed’s was basically static. The ratio grew to 1.09 to 1, and the exchange rate rose to just over $1.36 briefly surpassing $1.37 over the weekend.
The balance sheet ratio is an indicator of respective demand levels for each currency. When the Eurozone banks repaid their cheap loans from the ECB, they had to sell assets to raise the cash to do so. Whenever these banks sell foreign, mostly American assets, they must convert the dollar proceeds to euros to repay the ECB.
This trend will continue, and the Fed will continue to increase the size of its balance sheet through QEternity for at least the next year increasing the ratio even more. The euro should continue to increase in value choking exports. Moreover, banks that are increasing their capital are banks that are hesitant to originate new loans. Essentially, the ECB is running a tight money policy in relation to the other central banks, and this policy will deepen the Eurozone recession over 2013.