Dollar to retain the upper hand
23 Feb 2016
Posted in: Business
Despite a considerable amount of volatility on financial markets and diverging trends in US and eurozone monetary policies, the key euro/dollar exchange rate has been very range bound over the past year, largely trading in a $1.06-$1.15 corridor writes Oliver Mangan Chief Economist atAIB.
This period of stability followed the big exchange rate moves in the second half of 2014 and opening couple of months of 2015 that saw the euro fall sharply, declining from $1.40 to a low of $1.05.The slowdown in emerging economies, weakening commodity prices, as well as increased risk aversion and volatility in financial markets have helped currencies such as the euro and yen to stabilise over the past year, following their very steep losses in the period before that.
Very subdued inflation and the growing downside risks to global growth have made it difficult for central banks such as the US Fed and Bank of England to tighten monetary policy despite the strength of their own economies. As a result, over the course of the past year, markets greatly scaled back their expectations of rate hikes in the US and UK.
When the Fed finally did increase rates in December, it was well signalled and modest, with the key funds rate rising from 0.125% to 0.375%. Indeed, the euro has risen from $1.06 in early December to a high of $1.13 recently, even though the ECB loosened policy at the end of last year and has also hinted that a further easing of policy is likely in March that would take eurozone rates even deeper into negative territory.
The moves in ECB rates, though, are relatively small. The big change in recent months has been in relation to the expected future path of US rates. Up to recently, markets had been anticipating that there would be a series of rate hikes in the US. Now, though, markets think that the Fed will not raise rates again until late in 2017, with just very moderate increases in rates thereafter. The euro/dollar rate is currently trading at around $1.11, in the middle of the $1.06-$1.15 range that it has occupied since last spring.
Short-term interest rates look set to remain quite negative in the eurozone over the next couple of years, with the ECB also retaining an easing bias. Thus, it is hard to see the euro making significant gains against the dollar that takes it above the $1.15-$1.16 level, unless there is a shock to the US economy that causes the Fed to start easing policy. Much uncertainty still surrounds the actual extent of Fed tightening. The market is now not pricing in another rate increase until late 2017. However, the most recent projections from the Fed —published in December pointed to eight rate increases by then.
The Fed’s projections now look out of date but they do suggest that it feels the need to move rates higher, if at all possible. The unemployment rate has fallen to under 5% and the expectation is that the economy will continue to grow at a solid pace. It is not that surprising, then, that the Fed appears to have quite a strong bias in favour of tightening monetary policy.
Thus, unless the US economy slows dramatically in the next couple of years, it would seem to us that the Fed is likely to hike rates. In the near-term, volatile financial markets and some softening in US data are likely to keep the Fed on hold. However, we would expect US rate hikes to come back on to the agenda later in 2016, especially if financial markets settle down again and the economy continues to perform solidly. As we have seen in the past year, rate hike expectations are a key driver of foreign exchange markets.
Rate hikes should support the dollar as they are not being priced in by markets. Any rate hikes, though, are likely to be modest enough given the uncertain global environment. Thus, the dollar will probably find it difficult to push through $1.05-1.06, which has proved to be a strong support level for the euro over the past year.
Overall, then, we would expect the euro/dollar rate to remain range bound in 2016 but with the risks to the upside for the dollar from current levels, given that the market is not pricing in any US rate hike until late in 2017.