Euro benefits from growing risk aversion in markets

There have been some significant moves in global foreign exchange markets in the past few days as a pronounced pick-up in risk aversion sees currencies break out of well-defined trading ranges, writes Oliver Mangan Chief Economist at AIB.

The four major currencies have been confined to relatively narrow trading ranges against each other over the past few months, following big exchange rate moves in the second half of last year and the opening quarter of 2015.

In particular, the euro found a floor in the spring and became much more stable, after having suffered big losses in the second half of 2014 and early 2015.

The euro has been trading in a $1.08-$1.14 range versus the dollar since mid-April.

However, it has risen sharply over the past week, climbing from $1.10 to a seven-month high of $1.17 yesterday. The euro has also risen by four pence against sterling in the past week, climbing from just over 70p to around 74p.

The single currency is benefitting in a number of ways from the increased risk aversion in financial markets. Traders have been using the euro as a funding currency as interest rates are very low there, and then investing in other currencies.

They are now closing out these trades, selling their investments and buying back euros, which is causing the single currency to spike higher. In the meantime, there are growing concerns about the slowdown of the Chinese economy and sharp falls in equity markets.

“Many stock markets are down by well over 10% in the past week, with very big falls yesterday.”

The slowdown in China and associated financial market turbulence is seen as delaying the timing and extent of expected rate hikes in the US and UK. Furthermore, the renewed fall in commodity prices over the summer, which has been partly caused by the weakening of activity in emerging economies like China, is also having a similar effect on expectations for interest rate increases.

Inflation has fallen to around zero in many economies and near-term inflation forecasts have had to be lowered further as a result of the continued sharp decline in commodity prices, in particular oil prices. Inflation is now set to remain around zero for longer than was expected.

The very subdued inflation outlook, growing downside risks to global growth and turbulent financial markets are making it increasingly difficult for central banks, like the Fed and the 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 for rate hikes in both the US and the UK. At the start of 2015, 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 the Fed will keep policy unchanged this year and won’t hike rates until next spring. UK rates are now not expected to start rising until the middle of next year.

All of this is helping to support the euro, where rates are expected to remain very low, anyway, for a considerable period of time. Thus, there were no great rate hike expectations to scale back here.

The euro is now well off the floor of $1.05 reached against the dollar in the spring and the EUR/USD rate looks to be moving into a new higher trading range, certainly for as long as turbulence persists on financial markets.

In the meantime, it is hard to see the euro dropping below 70p against sterling anytime soon.

Indeed, the dollar and sterling seem unlikely to make renewed gains against the euro, unless markets are now underestimating the extent to which rates will rise in the US and UK over the next couple of years.

The current market turbulence will need to abate also.

Source: Irish Examiner August 25th 2015