Dollar still losing favour on currency markets
Since mid October it has fallen by nearly 5% against the euro, 5.2% against sterling and 1.8% against the yen. On a broad trade weighted basis it has depreciated by almost 2%. Attempted recoveries have proved to be short-lived.
With the euro breaking through support at a number of key resistance points, markets are now debating the likelihood of a move by dollar/euro to $1.40. Comments from the ECB suggest that it is relatively comfortable with the level of the euro versus the dollar. The eurozone is much better placed to deal with the currency’s appreciation compared to when it last traded through the $1.32 level in May 2005.
Furthermore, on a trade weighted basis, the euro is only up by 1.9% since mid October having recently lost ground against sterling, the Swedish krona and Norwegian kroner, as well as a number of Eastern European currencies, including the Polish zloty, Czech koruna and Hungarian forint.
Although it has not been a straight line depreciation, the dollar has been on a gradual weakening trend since March. The main catalyst for the recent sell-off has been renewed concerns about the US economy and expectations for lower interest rates in 2007.
The Fed last increased interest rates in June and markets are preparing themselves for an easing in monetary policy over the coming quarters. The economy is operating at below trend growth levels.
The dollar has also been hit by its usual December sell-off. With the exception of 2001/2002, the dollar has invariably weakened in December, which may reflect European companies’ repatriation of profits from US operations.
Some upside surprises in terms of US economic data have offered some relief to the dollar over recent days, with markets now pricing in rate cuts of 0.50% in the US next year, instead of the 0.75% that had been priced in at the start of December.
There could be some dips in dollar/euro as liquidity levels dry up ahead of year end, particularly if US data prove to be supportive. However, $1.305 appears to be offering good support for the euro and we expect further dollar softness in 2007.
A move to $1.35 is likely in the first quarter of 2007, with the ECB expected to increase interest rates again in either February or March. Moves much beyond this, however, may prove difficult.
Appreciation of this scale may also be a little less comfortable for the ECB. Furthermore, while the spread between US and eurozone interest rates should have narrowed considerably by end 2007, the absolute difference will still favour the dollar, which could dampen the euro’s enthusiasm.
While the euro has made significant gains versus the dollar, it has not fared so well versus other European currencies. Specifically, gains seen versus sterling in the wake of the Bank of England’s relatively dovish quarterly inflation report in mid-November have been eroded with strong data increasing the risk that British interest rates will rise to 5.25%.
There are near-term risks of another break of the 0.67p level if British numbers remain strong but, over time, the euro should return to the upper end of a 0.67-0.69p trading range.
Thus, as the year draws to a close, the expectation is that in 2007 the euro looks set to add to the 11% appreciation it has recorded versus the dollar over the course of this year.
Gains versus the dollar, however, could be mainly concentrated in the first half of the year. Meanwhile, it could also recover some ground against sterling.
