Volatility has dominated exchange markets

Last year was very much characterised by range trading and low volatility in currency markets.

The dollar-euro exchange rate was mainly confined to a $1.27-$1.33 range; sterling remained within $1.55-$1.65 against the dollar, while sterling-euro spent much of the year in a narrow £0.78-£0.83 range.

Only towards the end of 2012 was there a significant breakout by a major currency, when the yen went into freefall. The opening quarter of 2013, though, has seen a lot more volatility in forex markets.

The euro was the star performer in January, rising from $1.30 to $1.37 against the dollar and climbing from 81p to 87p versus sterling. Since then, the dollar has held the upper hand, regaining all the ground lost against the euro in the opening month of the year.

The dollar has also broken out of its well-established trading range against the pound, with sterling moving below $1.50 at one stage, down from $1.63 at the start of the year. The dollar has also made large gains against the weakening yen. Meanwhile, euro-sterling has been quite volatile in recent weeks, as has the yen-euro exchange rate.

The eurozone debt crisis has been a key factor impacting on currency markets in the past two years. The re-emergence of political and financial risk in the eurozone periphery, as well as the continuing recession in the eurozone economy, has seen an unwinding of the gains made by the euro against the dollar in January.

It has also seen the euro lose some ground against sterling recently, despite the difficulties that continue to beset the UK economy. Overall, despite the much improved sentiment in peripheral eurozone markets since last summer, recent events have demonstrated that problems persist.

The dollar has been a strong currency in recent times. It has risen by over 10% on a trade-weighed basis since mid-2011. It has put in a strong performance over the past six months in particular.

This is despite a further marked easing in US monetary policy, with the launch of an aggressive programme of quantitative easing by the Federal Reserve involving large scale, open-ended asset purchases. The dollar has also had to contend with much uncertainty in the US about fiscal tightening and a slowdown in growth.

However, the dollar has benefited from the fact that the US economy and labour market are in much better shape than elsewhere, with recession returning to both Europe and Japan but growth continuing in the US. As a result, there is an expectation that the US Fed will be the first of the major central banks to bring an end to policy easing.

There are still some medium-term downside risks for the dollar, notably the sizeable US twin deficit problem, in terms of its large fiscal and balance of payments deficits. The US economy, though, is expected to regain momentum during 2013.

This could fuel speculation that the Fed may start to wind down its quantitative easing programme before year-end, helping the dollar and outweighing any concerns about the twin deficits. In particular, the dollar can be expected to make further gains against sterling and the yen given that further quantitative easing is likely in both the UK and Japan this year. ECB policy, though, is expected to stay on hold, so the dollar could remain fairly range bound versus the euro at around $1.30.

This assumes, of course, that there is no major escalation of the problems besetting some of the member states in the eurozone’s southern periphery in recent times. In this regard, the euro remained relatively stable against the dollar last week despite the crisis which gripped Cyprus, as the markets expected that this matter would eventually be resolved.

* Oliver Mangan is chief economist with AIB