Challenging times ahead for declining euro

In recent months, the dollar has had a stronger tone, making gains against a basket of currencies.

This trend started to take hold earlier in the summer, with the currency being supported by improving economic data, which in turn saw the Fed start to hint at interest rates hikes from 2015.

The recent performance of the euro has been in stark contrast to the dollar. Weak eurozone data and ECB policy easing (with potential for more) have seen downward pressure on the single currency. It has been a slow decline by the euro.

Against sterling, the euro has fallen from close to 84p in March to below 80p in the past few months. The euro/yen rate has fallen from a high of ¥145 to below ¥140 during the summer months.

The euro has also moved steadily lower against the strengthening dollar over the past few months. It fell from close to $1.40 in May to below $1.30 in September. The move below $€1.35 in July was particularly significant, as it took the euro out of the €1.35-€1.40 trading range that it had occupied since last September.

In the week just gone, EUR/USD fell to around $1.27, while EUR/GBP tested the 78p level. Meanwhile, sterling has overcome its recent Scottish referendum-related volatility. Cable (GBP/USD) has steadied, trading in a narrow range near $1.63. The outlook and prospects for these currencies, over the coming months, will be influenced by the performance of their economies and monetary policy stances. In this context, ‘divergence’ is becoming the buzzword in financial markets.

The US and UK economies should continue to outpace the eurozone, where growth is expected to remain very sluggish. This means that both the Fed and Bank of England are likely to hike rates well before the ECB.

Market expectations are that the policy tightening could start in the UK and US in the first half of next year. Meanwhile, markets are not discounting eurozone rate hikes until 2017 at the earliest.

Thus, widening interest rate differentials should see the euro lose further ground against the dollar and sterling in the period ahead. However, both $1.27 and 78p are strong technical support levels for the euro.

The euro has not traded below 78p against sterling on a sustained basis since the collapse of the British currency in early 2008.

Meanwhile, although the euro dipped to around $1.20 against the dollar on a couple of occasions in recent times, these proved brief episodes. The euro has not traded below $1.27 on a sustained basis since 2006.

The market is now quite long the dollar, with futures contracts showing traders positioned for further gains by the US currency. This leaves the dollar vulnerable to any disappointing news that could cause traders to unwind these positions.

It should also be noted that the euro has shown considerable resilience in the past couple of years, despite the pronounced weakness of the economy. The euro has been supported by a current account surplus and capital inflows, including for reserve accumulation.

Nonetheless, we expect the market will test these key support levels for the euro if, as expected, the US and UK economies continue to perform well. US Fed and Bank of England rate hikes next year would most likely see further significant gains by their currencies against the euro.

Any move by the ECB towards full-blown quantitative easing would also be very negative for the euro. We saw the sharp fall by the yen last year on such a move by the Bank of Japan.

Taking all these factors into consideration, we would not be surprised to see the euro dropping towards the $1.20 level in the period ahead, with the EUR/GBP rate heading down to 75p.