Euro held back from comeback by easing bias

The four major reserve currencies (dollar, euro, yen, and sterling) have been confined to relatively narrow trading ranges against each other over the past six months. This follows a period of big exchange rate moves in the second half of last year and early part of 2015 writes Oliver ManganChief Economist atAIB.

That is not to say that there have not been big moves on forex markets in recent months. Currencies such as the Aussie, Kiwi and Canadian dollars have come under a lot of pressure from the weakness of commodity prices and associated slowdown in the Chinese economy.

Indeed, some emerging market currencies have seen quite large falls recently. The euro, though, has found a floor and become much more stable in recent months, after suffering big losses in the second half of 2014 and early 2015.

It has traded in a $1.08-$1.16 range versus the dollar since mid-April. Against sterling, it has largely traded in a 70p-74p range over the past six months.

The euro has benefited from the slowdown in emerging economies, weakening commodity prices and increased risk aversion and volatility in financial markets. The resulting downward pressure on inflation and growing downside risks to global growth have made it increasingly difficult for Central Banks such as the US Fed and Bank of England to begin tightening monetary policy, despite the strength of their own economies.

As a result, markets have greatly scaled back their expectations of rate hikes in the US and UK. At the start of 2015, the markets were looking for up to three 25bps rate hikes in the US this year. Even up to recently, there was an expectation that the Fed could hike rates in both September and December.

Now, though, markets think that Fed rates may not rise by a full 25bps until next summer. Meanwhile, UK rates are now not expected to start rising until late next year. All of this is helping to support the euro, as eurozone rates had been expected to remain very low for a considerable period of time in any event.

Thus, there were no major rate hike expectations to scale back here. A pick-up in growth in the eurozone this year is also helping the euro. The euro is now well off its floor of $1.05 against the dollar, reached earlier in the year. It has been trading in the $1.11-$1.14 range over the past few weeks.

It seems unlikely, though, that the euro will recover much further ground in the near term, given that the ECB retains a pronounced easing bias that could see it loosen monetary policy further in the months ahead.

Indeed, if a rate hike was to materialise in the US over the winter or spring, the euro could lose some ground again to the dollar. Meanwhile, it is hard to make an argument for a further strengthening of sterling. It has already risen by some 17% on a trade-weighted basis since mid-2013.

However, the UK has a large balance of payments deficit which would suggest that the currency is, if anything, overvalued. Growth in the UK economy has also slowed this year. Meanwhile, rate hikes look much further away from becoming a reality in the UK than in the US.

Finally, an important risk to bear in mind, regarding sterling’s prospects, is the referendum on the UK’s continued membership of the EU, likely to be conducted next year.

Sterling has softened recently, with the euro threatening to rise above the 74p level. It is difficult to say if this key resistance level will hold or give way. Any further loosening of ECB policy would likely cap the rise of the euro.

In any event, it is hard to see the euro falling back to 70p against sterling anytime soon, with UK rate hikes now looking a long way off, and a Brexit referendum expected next year.

Source: Irish Examiner October 6th 2015