Currency Volatility Set to Continue

A noticeable feature of foreign exchange markets this year has been much greater uncertainty and volatility,writesOliver Mangan,Chief Economist at AIB.

Key exchange rates have moved out of well-established trading ranges, while there have been big currency moves over short periods of time, as well as increased volatility, with currencies moving in one direction and then another.

The major trends are clear, though, with the dollar and sterling rising strongly against the euro in the year to date in a continuation of the trend evident for much of 2014.

Markets in recent years got used to central banks providing very clear signals on the direction of monetary policy, through so-called forward guidance on interest rates.

Central banks did not want markets thinking that they would start increasing interest as growth picked up.

Thus, they clearly indicated that rates could stay at zero for a considerable period of time and that they would exercise patience about when to commence policy tightening.

This clear forward guidance on interest rates, though, has come to an end in the US and in Britain. As a result, there is much greater uncertainty about the future paths of interest rates in both countries.

The economic recovery in both these economies has become well established, with their unemployment rates dropping sharply to around 5.5%.

Thus, both economies are moving into rate hike territory, which has driven their exchange rates higher over the past year.

However, with inflation falling to zero in both countries, their central banks still seem in no hurry to hike rates.

Furthermore, there are concerns that the marked appreciation of their currencies could slow their economic growth and/or lead to a prolonged period of low inflation.

The sharp fall in oil prices is an added complication as markets ponder how this will impact monetary policy.

Will more weight be attached to the resulting sharp drop in inflation or to the expected boost to growth from the much lower oil prices?

Even central bankers themselves seem to be unsure about this. The Bank of England looks set to keep policy very much on hold in the near-term as it assesses how the economy will perform in 2015.

Meanwhile, the US Fed has clearly indicated that upcoming economic data will have a major impact on its policy deliberations.

At its March policy meeting, there was no clear indication from the Fed about the timeline for policy tightening.

While the Fed downgraded its assessment of the economy, a rate hike in June was not ruled out. In this regard, it stressed that monetary policy decisions will be heavily influenced by upcoming data.

This is a recipe for continuing volatility on foreign exchange markets. Over the past month, we have seen the euro/dollar rate fall from $1.13 to $1.05, before rebounding to $1.10.

The dollar has strong technical support at around the $1.11-1.13 range, which will make it difficult for the euro to recover much further ground.

Thus, we would expect this exchange rate to move in a $1.05-$1.10 range until greater clarity begins to emerge about Fed policy and its rate hike intentions. We think the US economy will perform well over the balance of the year, triggering Fed rate hikes.

Thus, we expect the dollar to eventually push on towards parity versus the euro.

Meanwhile, the euro/sterling rate fell from 78p in early January to near 70p in early March before rising back up to close on 74p. We think it will trade in a 70p-75p range in the near term, with sterling remaining well underpinned.

One factor, though, that could trigger sterling weakness is the upcoming UK general election. In particular, if the Conservatives are returned to power, it would bring a referendum on EU membership right on to the agenda, casting a major cloud over sterling.

Election risks aside, we would expect sterling to retain the upper hand against the euro in 2015.

Source: Irish Examiner March 31^st 2015