Oliver Mangan, Chief Economist at AIB, discusses how the marked strengthening of the dollar, evident over the second half of 2014, continued in the early part of 2015.

Slowdown in US Economy Puts Pressure on Dollar

Slowdown in US Economy Puts Pressure on Dollar

The marked strengthening of the dollar, evident over the second half of 2014, continued in the early part of 2015, writes Oliver Mangan Chief Economist at AIB.

 

The US currency gained around 13% against the euro and 6.5% versus sterling between the end of 2014 and mid-March, with the euro falling from $1.21 to $1.05.

 

Since then though, the dollar has come under pressure and, over the past month, has surrendered some of the gains made earlier in the year.

 

The euro has climbed to $1.14, while sterling has more than recovered all the ground it lost earlier in the year, rising by almost 12 cents to near $1.58.

 

The principal reason for this is the marked slowdown in US activity in the opening quarter of the year that has seen the economy virtually stagnate.

 

While this is largely being attributed to temporary factors, such as severe weather, it has still seen the markets scale back their expectations for rate hikes by the US Federal Reserve this year.

The fall in the annual consumer price index inflation rate to zero has also been a factor in this regard. As a result, markets are now looking for just one 25 basis points Fed rate hike towards the end of the year.

 

At the start of 2015, the markets were looking for up to three 25 basis points rate hikes this year.

 

By contrast, the eurozone economy has been performing better than expected in 2015. Growth picked up to 0.3% in the final quarter of 2014 and accelerated further to 0.4% in the first quarter of 2015.

 

There has been an improvement in monetary aggregates too, while the region has also emerged from a period of negative inflation.

 

While Greece remains an ongoing concern, with much discussion about a possible Greek exit, there has been a general improvement in sentiment towards the eurozone economy.

 

Quantitative easing is seen to be working, while bond yields have also risen from very low levels recently; providing a further support to the currency.

 

A very noticeable feature of currency markets in 2015 has been increased volatility. Key exchange rates have moved out of well-established trading ranges, while there have been big currency moves over short periods, as well as higher volatility, with currencies moving in one direction and then another.

 

Clear forward-guidance on interest rates from the US Fed and Bank of England has come to an end. As a result, there is much greater uncertainty about the paths of interest rates in both countries. It is clear that monetary policy decisions will be heavily influenced by upcoming data, especially in the US, where the Fed appears to be closer to hiking rates than the Bank of England. This is a recipe for continuing volatility on foreign exchange markets.

 

We think the US economy will regain momentum, after its recent slowdown, and perform solidly over the balance of the year. There are numerous factors supporting growth, such as lower energy prices, rising incomes, reduced fiscal drag and low interest rates.

 

Thus, we would not be surprised to see a couple of Fed rate hikes in the latter stages of 2015, with more to come in 2016. This should allow the dollar to resume its upward trajectory.

 

However, given the improving eurozone economy and rising yields there, our earlier expectation that the dollar could push on to parity versus the euro later this year, may now be too ambitious.

 

By year end, though, it could retest the level of $1.05 seen in the spring. It should also recover some of the ground lost to sterling in the past month, with the UK currency falling back towards the $1.50 level or below. All this, though, is critically dependent on the US economy regaining momentum. If this fails to happen, the dollar will continue to lose ground.

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