ECB President Draghi was unable to arrest the US dollar’s slide and euro’s surge. But he did not try particularly hard. 

While many investors are a bit stumped by the pace and magnitude of the dollar’s slump, Draghi seemed to imply that it was perfectly understandable given the recovery of the eurozone economy. The economy is the strongest it has been in more than a decade, but the US is no slouch. The US reports the first official estimate of Q4 GDP tomorrow January 26 and it will likely be the third consecutive quarter of above 3% growth. 

How are growth impulses transmitted to the capital markets? One channel is the demand for capital is expected to increase and this may increase real interest rates.Another channel is inflation. As the output gap closes, and rising input costs are passed on to customers, the general price level rises.In turn, the central bank is likely to adjust monetary conditions. This results in widening interest rate differentials.  

The relationship between interest rates and exchange rates is not linear but cyclical. As a currency depreciates or is anticipated to decline, investors demand a greater interest rate premium to compensate for exchange rate risk. Over time, a sufficiently higher interest rate attracts flows back into it. Later, the currency begins to appreciate and the higher interest rate is no longer needed. The interest rate declines as the currency appreciate. Rinse and repeat.  

By recognizing what he called endogenous factors (namely the macroeconomic improvement), Draghi accepted and validated the euro’s rise. In the context of recognizing that the currency needed to be monitored (when doesn’t it?), investors grasped Draghi’s remarks as milquetoast effort to push against the market and the euro’s rise. So it rose further. 

Draghi could not push much harder. First, without new staff forecasts, his hands are tied. Also, the rise of oil has likely more than offset the rise of the euro in terms of impact on general prices (inflation). Secondly, Mnuchin’s comments clearly impacted the ECB’s discussion. While Draghi identified endogenous drivers for the euro, he also an exogenous driver. Without citing Mnuchin by name, Draghi clearly made reference to his remarks. Moreover, he noted that those comments violated the international agreement, and the IMF’s Lagarde seemed to echo a similar sentiment in Davos.