The Fed and the ECB Expected to Head in Opposite Directions

Answer the following questions to check your understanding of the story.

If the ECB raises interest rates and the Fed lowers interest rates, how will the U.S. dollar/euro exchange rate change?

The U.S. dollar ____________.

a) will fall against the euro

b) and the euro will rise together

c) will rise against the euro

d) and the euro will fall together

Wrong! - A falling U.S. interest rate differential makes investors want fewer dollars and more euros. If the euro rises, the dollar must fall. If the dollar falls, the euro must rise.

Correct! - The dollar falls because lower U.S. rates and higher Eurozone rates make euro assets more attractive.

What is a bond yield?

Bond yield is the ____________.

a) fixed interest payment a bond makes to its buyer

b) fixed interest payment a bond makes to its buyer divided by its face value

c) fixed interest payment a bond makes to its buyer divided by the bond’s market price

d) nominal interest rate on a bond multiplied by its face value

Wrong! - Bond yield always uses the market price, not the face value. Coupon rate × face value gives the coupon payment, not the yield. The fixed interest payment is the coupon, not the yield.

That's Right! - Bond yield is the coupon payment divided by the bond’s market price.

Why have bond yields risen in Europe?

Bond yields have risen in Europe because ____________.

a) the demand decreased while supply remained unchanged, lowering price and lowering yields

b) the demand increased, raising price and raising yield

c) the supply decreased while demand stayed unchanged, raising price and raising yields

d) the supply of bonds increased, lowering price and raising yield

Wrong! - Demand won’t rise for low-rate old bonds when new ones pay more. If bond prices rise, yields fall—so a decrease in supply while demand stayed unchanged cannot explain rising yields. Low-rate bonds won’t see higher demand or unchanged supply when better-paying new bonds appear.

Good Job! - Higher interest rates make old low-rate bonds unattractive, so selling pressure lowers prices and raises yields.

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