Oliver Mangan, Chief Economist at AIB, discusses how the US currency gained around 11% against the euro and 6% versus sterling in the opening three months of the year.

The Currency Markets Are Still Volatile

The Currency Markets Are Still Volatile

The marked strengthening of the dollar, evident over the second half of 2014, continued in the early part of 2015. The US currency gained around 11% against the euro and 6% versus sterling in the opening three months of the year, writes Oliver Mangan, Chief Economist at AIB.

 

Expectations that the US Federal Reserve will increase interest rates later this year, when they are set to remain on hold elsewhere, has been the key factor driving the dollar higher.

 

Indeed, further monetary easing across the globe in recent months highlighted the emerging difference between the stance of monetary policy in the US and elsewhere. Nowhere is this contrast more evident than with the eurozone.

The euro has lost considerable ground over the past year as the persistence of very weak growth there, coupled with a fall in inflation to very low levels, forced the ECB into further policy easing. This culminated in the launch of a full-blown quantative easing (QE) programme this year.

 

Key exchange rates have moved out of well-established trading ranges in 2015, while there have been big currency moves over short periods of time.

 

The euro/dollar rate fell from around €1.25 in mid-December to a 12-year low of €1.05 in mid-March. Similarly, the euro fell through the key support level of 78p versus sterling at the start of the year, declining to close on 70p.

 

Another noticeable feature of FX markets this year has been increased volatility, in part, related to central bank policy changes. The ECB’s move to full-blown QE has weighed heavily on the euro.

 

Meanwhile, surprise easing announcements from central banks such as the Bank of Canada, Reserve Bank of Australia and the Swedish Riksbank resulted in a weakening of their respective currencies.

 

The SNB caught markets completely off guard with the shock decision to discontinue the policy of capping its currency’s exchange rate against the euro, resulting in sharp appreciation of the Swiss franc.

 

Clear forward-guidance on interest rate policy from the US Fed and Bank of England has also come to an end.

 

As a result, there is much greater uncertainty about the future paths of interest rates in both countries.

 

It is clear that monetary policy decisions will be heavily influenced by incoming economic data, especially in the US, where the Fed is closer to hiking rates than the BoE.

 

This is adding to the volatility on currency markets. The dollar rally has run out of steam in recent weeks, with the currency experiencing considerable volatility against the euro and sterling, albeit within quite well-defined trading ranges.

 

The dollar has been impacted recently by soft US economic data, which have added to uncertainty about when the Fed will begin to tighten US monetary policy.

 

There is no doubt that one-off factors, such as severe weather and a strike by port workers, have caused US data to come in well below expectations in the past few months.

 

However, there may be concerns that poor recent data could be pointing to some underlying weakness in the economy.

 

Markets will be looking for a marked improvement in US data in the coming months to confirm that the slowdown in the economy is indeed temporary.

 

This would help reaffirm expectations that US rates will rise later this year, which should allow the dollar to resume its uptrend.

 

Another feature of currency markets, in recent weeks, has been the strength of sterling ahead of the UK general election.

 

However, we would not be surprised to see trading in sterling turn more volatile.

 

There is a clear risk of an outcome to the UK election that markets view as negative for the currency. The outcome of the election is unclear.

 

It could result in an unstable, minority government. It is also uncertain if there will be a referendum on the UK’s continued membership of the EU in the new Parliament.

 

Either event could create uncertainty around sterling.

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