Euro may dip below 70p if UK hikes rate

The recent progress in terms of a solution to the Greek debt crisis has allowed the focus on markets to shift back to underlying fundamentals. 

In this regard, the attention is back on the prospects for divergence in global monetary policy, with the potential for both the US Fed and the Bank of England to start hiking interest rates in 2015/16 well before the ECB, where interest rates are not expected to start rising until 2018.

Central bank events and speeches in recent weeks have served as a reminder that we are getting closer to this point of divergence in global monetary policy. Both the Fed and Bank of England have started to reaffirm some of their hawkish credentials.

On the Fed front, chairwoman Janet Yellen gave an upbeat assessment of the US economy in her semi-annual testimony to Congress, noting that “prospects are favourable for further improvement in the US labour market and the economy more broadly”. She also communicated that the Fed remains of the view that “it will be appropriate” to raise interest rates at some point this year. Meanwhile, another Fed member stated that “September would be a very plausible time to start lift-off”.

The Fed’s most recent interest rate projections, released at its June meeting, continued to show a more aggressive path of rate hikes than the market is currently expecting.

Its projections suggest the potential for two rate hikes this year, whereas, the market is not expecting the first full 25bps increase until year end.

Meantime, BoE governor Mark Carney, in his appearance before the Treasury Select Committee, said “the point at which interest rates may begin to rise is moving closer”.

In another speech, the governor elaborated further on the outlook for UK monetary policy, stating that the decision on when to start increasing interest rates will “likely come into sharper relief around the turn of this year”.

Current market pricing suggests that markets do not expect a UK rate hike to happen until spring 2016. Given the tightening labour market and pick-up in wage inflations, along with the more hawkish rhetoric coming from the Monetary Policy Committee, rates could be increased early next year.

In contrast, at the July ECB governing council meeting, president Mario Draghi reiterated there will be “full implementation” of its QE programme.

Thus, purchases will continue to run at a rate of €60bn per month until at least September 2016. He also emphasised the ECB’s willingness to ease policy further if conditions warranted it, stating that the Central Bank would “respond to such situations by using all the instruments available within its mandate”.

Not surprisingly, with the market focus shifting back to monetary policy, the euro has started to come under some renewed downward pressure against both the dollar and sterling.

EUR/USD has tested below the $1.09 level in the last fortnight.

Likewise, EUR/GBP dropped below the 70p mark, trading down to its lowest level since November 2007 before managing to regain some of this lost ground.

Looking ahead, there is potential for further downside in the euro against both the dollar and sterling.

The main driver of this could be strength on the part of the dollar and sterling, linked to the rate-tightening appetite of theirrespective Central Banks.

If there was significant Fed tightening, starting in the autumn, we could see the EUR/USD pair trade back down towards the $1.05 level.

Similarly, if UK rate hikes were to materialise earlier than markets expect, then sterling may make further gains against the euro later this year.

Thus, the EUR/GBP could trade below 70p in these circumstances.

Of course, any policy tightening is data dependent.

Therefore, markets will be very much in data-watching mode over the coming months, analysing key data releases from both the US and UK economies, as they try to ascertain the timeframe for increases in interest rates.