OLIVER MANGAN: More currency volatility seems to be on horizon

A key development in currency markets in 2017 was the strengthening of the euro and weakening of the dollar, writes Oliver Mangan

The euro made impressive gains against the dollar, climbing from $1.04 to $1.20. This trend has continued in the early part of 2018, with the Euro-Dollar rate climbing to a three-year high above the $1.22 level.

It is important to remember that the dollar lost ground against a broad range of currencies last year and not just the euro.

Over the summer, the Australian, New Zealand and Canadian dollars rose to their highest levels in over two years against the US currency.

Even the Chinese yuan, which declined steadily against the dollar over the 2014-2016 period, appreciated against the greenback, while sterling rose to above $1.35 from $1.22 earlier in the year.

The dollar, though, stabilised and, indeed, gained some ground over the closing months of 2017, as the Federal Reserve prepared to hike rates again and President Trump succeeded in getting major tax cuts through Congress.

However, it has come under renewed downward pressure against a broad range of currencies since Christmas, including the euro, sterling, yen and Chinese yuan.

It is hard to pinpoint the precise factors behind the latest phase of dollar weakness. A rally in commodity prices — notably oil, improving data outside the US, concerns that China may not continue buying US Treasuries, doubts about the extent of further Fed tightening and a scaling back of quantitative easing (QE) by central banks in the eurozone and Japan — have all been cited as reasons behind the latest bout of dollar weakness.

The dollar has also proved immune to good economic data out of the US, in a clear sign that it is out of favour with markets at present.

Traders need to be wary, though, as recent changes to corporate tax rates in the US could spark dollar buying, should American companies start to bring back cash from overseas to take advantage of a special low tax rate on repatriated profits.

It is difficult to put a figure on the size and timing of such flows, but they should benefit the US currency as companies will need to convert funds held in other currencies into dollars.

The US currency fell sharply over the 2002-2008 period, except for in 2005, when a similar corporation tax amnesty that year led to a temporary but marked rise by the dollar.

Market positioning is also quite short dollar and long euro at the present time, which could limit the upside for euro-dollar trading.

Thus, we could be in for some volatility in foreign exchanage markets in the months ahead, with investors inclined to take the US currency lower, but significant dollar buying on repatriation flows is also quite possible.

The $1.21 resistance level has been overcome by the euro, opening the door for further gains.

However, if we are correct in our expectation that the US tax amnesty on overseas profits will see inflows into the dollar as corporates move to repatriate funds, then we are likely to see periods of US currency strength during the year.

Longer term, it should be noted that the euro is still at a relatively low level against the dollar. The euro and dollar mainly traded in a $1.20-$1.50 range from 2003 to 2015.

Thus, any gains by the dollar against the single currency this year are likely to prove temporary.

Hence, we think that 2017 marked the start of a long-term uptrend by the euro against the dollar, supported by an improving economy, large eurozone balance of payments surplus and the ECB starting to scale back its large QE bond buying programme.

Oliver Mangan is chief economist at AIB


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