The US dollar has appreciated significantly vis-à-vis the euro in the past months. For this trend to continue, at least two developments would have to be in place. Firstly, the US Fed would have to abandon its zero interest rate policy; and secondly, the ECB would have to remain on its path of negative interest rate policy and bond purchases.
The driving topics on the financial markets are the stabilisation of the oil price, mixed economic indicators globally vs. positive economic indicators for the Eurozone, the temporary decline in escalation risk, and the expansive central bank policies.
Since the cutting of key-lending rates to almost zero in the Eurozone did not suffice to keep the inflation expectations at their long-term target of slightly below 2%, the ECB Council decided in January to expand the central bank money supply until the accomplishment of the target was foreseeable.
The possible effect on the financial market and the economies are multi-faceted. 1) The excessively low inflation expectations increase. This will cause real interest rates (i.e. nominal interest rates minus inflation) to fall. 2) The currency (i.e. the euro) depreciates vis-à-vis other currencies. 3) A so-called asset price effect is created. The ECB buys bonds with low yields, resorting to the central bank money supply. This keeps bond yields very low (partially even negative). Given that, and because the volume of government bonds investable by the private sector shrinks, investors are pushed into asset classes with higher expected yields (bonds with long maturities, bonds with higher default risk, bonds with higher coupons in a foreign currency). This crowding-out effect supports asset prices. The net worth of the holders of these asset classes increases. 4) The willingness of banks to grant loans is supported by the very low bond yields.
The environment has become a bit brighter in the past weeks.
In addition to the improvement of the economic environment in the Eurozone and Japan, more and more central banks loosened their monetary policies. For example, on 12 February the central bank of Sweden (Riksbank) surprisingly cut its key-lending rate to -0.1% and announced to buy small volumes of government bonds. The reason behind this measure is the same as for similar steps taken by other central banks: the risk of falling short of the inflation target has increased. The markets reacted in a textbook-fashion with falling yields and a depreciating currency (krona). Both are supportive to the economy. On the financial markets the continuously falling and partially even negative yields of government bonds have pushed investors into securities with a higher expected yield (bonds with longer maturities, bonds with a higher default risk, bonds in foreign currencies, shares).