In recent weeks, two of the major central banks in the world have surprised the markets. On 21 January, the ECB has basically promised to provide more stimulus at its next meeting, which will take place on 10 March, whereas on 29 January the Bank of Japan created a surprise by introducing negative interest rates. On 27 January, the Federal Reserve insisted it is “closely monitoring global economic and financial developments”. Admittedly the reference to the international environment didn’t come as a surprise but it did reinforce the dovish tone of the press release after the FOMC meeting.

The following chart shows the evolution of the euro, the yen and the US dollar since the start of the year as well as the evolution of 10 year government bond yields in Germany, Japan and the US. The vertical lines show the dates of the ECB and BoJ meetings.

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The news from the ECB meeting on 21 January had a small negative impact on the EUR/USD rate and the BoJ decision pushed up the USD/JPY exchange rate. Today, barely two weeks after the ECB meeting the euro is stronger against the dollar than before the meeting. The yen has also strengthened against the dollar in comparison to where it was before the BoJ meeting last week.

Looking at bond yields, the increased uncertainty about the global outlook has caused a decline in Germany, Japan and the US since the start of the year. In Germany and Japan, the effect of the respective central bank meetings on bond yields has been more lasting than as far as the exchange rate is concerned. This may also reflect a more global phenomenon considering that US yields have declined quite a bit. This in turn implies, mechanistically, that the likelihood of Fed tightenings in the remainder of the year has declined a lot: for a hike on the occasion of the 15-16 March meeting it is 10%, for a hike by year end it is 50%. This evolution explains the very recent strengthening of the euro and the yen against the dollar. In the absence of a renewed increase of the chances of a Fed rate hike, it would mean that the exchange rate as a channel of transmission of monetary policy in the euro area and Japan would be blocked, unless the ECB and the BoJ would create another surprise. More than the central bank action, it seems that the strength or weakness of the US data will be of overriding importance. Indeed, the big difference in yields is a reminder of how tempting it will be to put on carry trades funded in euro or yen provided that the US numbers justify this.