Further gains for sterling on the horizon

Tight trading ranges for the main forex rates were a key feature of the currency markets in 2013, apart from the yen, which fell sharply.

The euro/sterling rate was largely confined to a 83p-87p range in 2013, while the euro/US dollar spent most of the year trading in a $1.28-$1.36 band.

Last year, FX markets operated against a backdrop of central banks moving into forward guidance mode and trying to convince markets that interest rates could remain at low levels for an extended period of time. This helped to keep the main currencies quite range bound.

An important factor for FX markets this year will be the relative macroeconomic fundamentals. This in turn will determine the respective monetary policies of the main central banks over the medium term.

Monetary policy looks set to remain very loose in the eurozone and Japan over the next couple of years, with no rate hikes in prospect. This is a reflection of the weakness of their economies, which are forecast to show only modest growth in 2014/15.

By contrast, the US and UK economies are gaining momentum. If expectations of strong growth by both these economies this year prove correct, it is likely to see a firming of market expectations that we will get a tightening of monetary policy by the Fed and Bank of England from next year on. Interest rate spreads should move in favour of the dollar and sterling in these circumstances, pushing their exchange rates higher.

In terms of the outlook for the dollar, then, our bias would be for the currency to rise in the year ahead, provided there is a sustained pick up in the US economy. This should see the Fed wind up its asset purchase programme by end year, with growing expectations that US monetary policy will be tightened from 2015. The euro/dollar rate could move down to $1.30 in these circumstances from around $1.37 at present.

Turning to sterling, there was a marked but unexpected improvement in the UK economy last year, with GDP growing almost 2%. This saw sterling recover the ground that it lost at the start of 2013 and it finished the year on a strong note.

The debate in the UK has now moved on as to when the Bank of England might start to hike rates. Improving labour market figures, robust purchasing managers’ indices readings and strong GDP data have seen the markets begin to discount that policy tightening may commence by the end of this year or in early 2015. As a result, sterling has continued to perform well.

Sterling is likely to continue to be supported by an improving macroeconomic backdrop. The relative strength of the UK economy compared to the eurozone, and the likelihood that the Bank of England will hike rates before the ECB, provides the potential for sterling to make further gains against the euro.

Sterling faces strong resistance at the 82p level versus the euro, which it tested briefly last week. If it can get through this level, we could see a move to 80p or below in the euro/sterling rate as the year progresses.

Meanwhile, with both the UK and US economies on similar trajectories and both their central banks expected to tighten policy by next year, the sterling/dollar rate could be quite range bound in 2014. There is the potential, though, for sterling to make gains if it becomes increasingly likely that the BoE will start to hike rates well ahead of the Fed.

Sterling has risen to around $1.66 recently. It faces stiff resistance in the $1.67-$1.69 region. This could prove difficult to overcome as it would see the sterling/dollar rate returning to levels not seen since before the collapse of UK currency in 2008. Nonetheless, sterling is looking quite strong and one can’t rule out more gains for it against the dollar.

Oliver Mangan chief economist, AIB


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