The euro has been on a steady upward path against the dollar for much of this year as it climbed from $1.04 in early January to around the $1.20 level by August, writes Oliver Mangan.
However, the euro-dollar rate has been range-bound since then, with trading confined to a narrow $1.16 to $1.20 corridor, as some of the shine came off the single currency while the dollar became more stable.
Part of the reason for this was the ECB announced in the autumn that it was extending quantitative easing, or its asset-purchase programme, until at least September 2018, though at a reduced rate from the start of next year. It also continues to indicate that interest rates will remain at the current, very low levels well past the end of net asset purchases under its quantitative easing programme. Thus, markets do not see a hike in ECB rates until 2019.
The dollar has been more stable in recent months too. Indeed, it has recovered some of the ground lost to currencies earlier in the year. It has been helped by the fact that the Fed reaffirmed it would continue to raise rates at a steady pace and indicated that the next rate increase was likely to occur before year end.
The Trump Administration has also made some progress with Congress on its tax-cut plans, which it wants to see next year. The US economy grew at a 3% annualised rate in the last two quarters. As a result, there has been a firming of market expectations in regard to US rates since the summer. Markets now see the next US rate hike occurring at the end of this year, while they also expect US rates to rise to 2% by the end of 2019.
We see the upside potential for the dollar next year as being closely linked to president Trump getting his tax-cut plans through Congress. Loosening fiscal policy at this stage of the cycle would add to the case for monetary tightening and likely see markets price in even more rate increases.
Furthermore, if there is also a one-off additional cut to corporate tax in an amnesty to entice back profits held by US corporates overseas, as is being mooted, then this also should trigger dollar gains. US companies will likely have to move some funds to dollars to repatriate them. The dollar is not a one-way bet against the euro. If inflation remains subdued in the US, the Fed may not tighten policy as much as it has indicated.
Rates are likely to rise to 2.75% by the end of 2019, but continuing low inflation would throw this into doubt.
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