There are three reasons why negative ECB rates can have a large impact on the euro.
First, even in a ZIRP world, the FX market remains very sensitive to short-end rates. Running regressions across all tenors, the correlation between EUR/USD and rate differentials is largest in the short-end of the curve. Not only that, but the beta is high – a 10bps move in yields is associated with a 3-4big figure move in the currency (chart 1).
Second, the effect on FX once the zero bound is crossed will likely be non-linear. On the one hand, it will be the first time a major central bank “pays” investors to short the currency. Swiss money market rates briefly turned negative in the crisis but the SNB never charged banks for deposits. Denmark also has negative rates but this is to defend a fixed exchange rate. If the euro becomes the first major funder with NIRP (negative rate policy) rather than ZIRP status, portfolio shifts are likely to be larger than usual.
Read the full report: FX Daily
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