For the first time in 20 years, the Euro and US Dollar exchange rate are at parity. Why is this, and what does it mean for you?
As to why this happened, there are a myriad of complex reasons, including demographics, trade, and expected GDP growth, but the immediate one is interest rates. See, while both the US and EU suffered inflation resulting from massive fiscal stimulus and government spending during the pandemic, the US Fed has recently been going crazy with hiking interest rates to manage inflation. The current rate is 1.5%, and 0.5%-0.75% increases are expected to occur regularly in the coming weeks and months. Meanwhile, the EU is staying at a cozy -0.5%.
When there is such a shift in interest rates, investors can earn more on their money by parking it in the US rather than keeping it in the EU. This increases demand for the dollar relative to the Euro, and causes the exchange rate shift we are seeing.
Now let’s talk about why you should care.
Well, first of all, you get to save on travel in Europe. You’re already getting a 20% discount at this point and the trend is expected to continue. I’m really looking forward to that trip to Rome now.
But these interest rate hikes also have large implications for how you should manage your fixed income portfolio.
In the fixed-income world, bond prices and interest rates move inversely. In short, when interest rates go up, existing bonds get priced more cheaply. An intuitive way to think about this is that an existing bond yielding 2% looks a lot worse when new bonds are yielding 3%. To make up for the deficiency the bond should decrease its price to be of equal attractiveness.
Interestingly Series I and Series E bonds don’t suffer from this phenomenon as they’re not traded on secondary markets and can be redeemed at par value.
Rebalancing in a portfolio can help to alleviate some of these ups and downs. When you deviate too far from your target bond mix, you can always buy or sell more bonds. In a rising rate world, it may be smart to start buying bonds to help reach your target allocation as existing bonds in your portfolio start losing value. This helps keep a consistent risk profile and serves as the basis for a well-balanced portfolio that can survive any environment.