Fed’s slowness to raise rates limits dollar’s potential

A notable feature of currency markets since early last year has been the stable trading range for the euro-dollar exchange rate following its sharp fall in 2014.
Fed’s slowness to raise rates limits dollar’s potential

There have been big moves by some of the other major currencies in the past year, in particular sterling.

However, the euro/dollar has been confined to a $1.06-$1.16 trading band since early 2015 and a $1.08-$1.15 range so far this year.

The dollar has been making some ground against the euro, though, since the single currency hit a high point for this year of $1.15 in early May.

Growing expectations that the Fed will hike rates before the end of the year, partly fuelled by an improving US economy, have seen the euro drop back below the $1.10 level in the past fortnight.

There are also a number of negative factors that present challenges for the single currency. The combination of Brexit uncertainty and associated risks for the EU, as well as an under-performing eurozone economy are headwinds for the euro.

There has also been further significant ECB policy easing this year, including a lowering of the deposit rate to -0.4%, as well as an expansion of its quantitative easing programme. As a result, many eurozone bonds now carry a negative yield.

The ECB also continues to maintain an easing bias on monetary policy, in marked contrast to the Fed.

However, despite the recent dollar gains, we do not expect a breakout anytime soon from the $1.06-$1.16 trading range against the euro evident since early 2015.

The rate hike expected before year end is modest at 25 basis points (bps), which would bring the official rate up to 0.625%. Hence, with US rates still very low, we expect the pair to trade in a $1.06-$1.11 range in the coming months.

Turning to 2017, we would need to see further rate hikes by the Fed for the dollar to maintain its recent uptrend against the euro and break out of its 2015-16 trading range.

The Fed is projecting two further 25bps rate hikes next year, to be followed by three more in 2018. This would bring the Fed funds rate up to 1.875% by end 2018.

Despite the Fed’s rate projections, though, there seems a clear reluctance by many Fed policymakers to raise interest rates.

They have had ample opportunity to do so in recent months, but have failed to act. Indeed, markets are pricing in only one Fed rate increase between now and the end of 2017, with just one further hike to follow by the end of 2018.

Thus, markets see official rates staying below 1% in the US over the next couple of years. This expectation by markets of a continuation of a low interest rate environment in the US is limiting the upside potential of the dollar.

Hence, we would need to see the Fed surprise markets and deliver some unexpected rate increases in the coming year for the dollar to push higher and rise towards parity against the euro.

As already noted, though, there seems quite a reluctance amongst most Fed policymakers to pursue a policy of steady rate hikes. They believe this is not necessary as US inflation is expected to remain low despite a sharp fall in the unemployment rate to around 5%.

However, any sign that the Fed could be proved wrong on inflation, such as a pick-up in wage growth, would send the dollar racing higher.

Elsewhere, a combination of risk aversion and market uncertainty has provided strong safe haven support for the yen this year.

Oliver Mangan is chief economist at AIB

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