Resilience of the euro is to be put to the test

Tight trading ranges for currencies remains a key theme in foreign exchange markets.

This is not to say, however, that we have not experienced some volatility and movement out of ranges in recent months.

The surprise decision from the Fed in September not to begin tapering its quantitative easing or asset purchase programme, caused some fluctuations in markets, especially for the dollar, which lost some ground.

More recently, the unexpected rate cut from the ECB resulted in some downward pressure on the euro, which fell from a peak of $1.38 back to around $1.34-35 against the dollar.

Trying to predict when and how the major currencies will break out of their ranges is not an easy task. This is because the outlook for foreign exchange markets is set against a backdrop whereby the main central banks rates are all indicating that interest rates can remain at very low levels for an extended period of time.

Therefore, an important factor on these markets over the medium term will be relative macro economic fundamentals, which in turn will determine the respective monetary policy stances of the main central banks.

In terms of the medium term outlook for the dollar, our bias would be for some upside for the currency, provided key factors become supportive of the currency — a definitive resolution to the budgetary/debt ceiling issue, the commencement of quantitative easing tapering by the Fed, as well as a sustained pick up in both the economy and jobs growth. These would all help the dollar to make gains.

Meanwhile, the euro has proved a resilient currency this year. It has hardly been impacted by the ECB rate cut in May, some further tensions within the eurozone this year, or the weakness of the economy.

Nevertheless, the weakness of the eurozone’s economic recovery relative to both the US and UK, combined with the fact that the ECB remains very much in policy easing mode, while both the Fed and the BoE could tighten policy earlier, could result in some downward pressure on the euro over the medium term.

Under this scenario, there is potential for the euro to gradually edge lower against both the dollar and sterling over the coming quarters, especially if expectations build that rates will be hiked in the US and UK in 2015, while remaining on hold in the eurozone.

The euro/dollar rate could move down near $1.30. Indeed, it could fall below the $1.30 level later in 2014 if interest rate expectations move decidedly against the single currency.

Meanwhile, after a sharp fall early in the year, sterling has regained ground in line with the recovery in the UK economy. It has risen from lows of below $1.50 against the dollar to back up above $1.60.

Against the euro, sterling has returned to the 83-84p level from lows of 87.5p.

Overall, sterling is likely to continue to be underpinned by an improving economic backdrop. The relative strength of the UK recovery compared to the eurozone, and the likelihood that the Bank of England will hike rates before the ECB provides the potential for some gains for sterling versus the euro in the coming year. Euro/pound could fall towards the 80p mark over this timeframe.

Meantime, with both the UK and US economies on similar trajectories and broadly similar expected timeframes for the commencement of policy tightening, sterling/dollar could largely trade in a $1.57-1.63 range in 2014.

Finally, the marked expansion in Japanese money supply is a negative influence on the currency. Higher interest rates in the other main markets also make yen investments less attractive. We expect the Japanese currency to move gradually lower over the coming quarters.


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