Will the recent USD weakness against the EUR continue?

Financial Article 427 by Edward Rizzo - Mar 24, 2016

During the course of 2015, one of the most talked-about themes across international financial markets was the strength of the US Dollar against most currencies, especially the euro. The US Dollar strengthened by 10.2% during 2015 from a rate of USD1.21 per EUR1 in January to a year-end level of USD1.086.

Some international economists and financial analysts were even projecting that the exchange rate will reach parity, i.e. the value of one euro would be equivalent to one US Dollar.

However, since the start of 2016, we have so far witnessed a movement in the opposite direction. In fact, the US Dollar has weakened by over 3.7% against the euro, from a EUR/USD rate of around USD1.085 at the start of the year to USD1.13 last week.

Since currencies are valued against one another, the performance of a currency signifies relative strength or weakness against another currency. In this case, the movement of the EUR vs USD exchange rate is dependent on factors affecting the US economy as well as developments across the Eurozone, and more importantly the monetary policy decisions and expectations by the Federal Reserve and the European Central Bank (ECB).

Until a few months ago, general expectations were that the US Dollar would continue to strengthen against the euro driven by monetary policy divergence. The US Federal Reserve (Fed) was expected to raise interest rates while the ECB would, on the other hand, continue to increase its dose of monetary stimulus, thereby leading to a weaker Euro.

In December 2015, the US central bank brought to an end the zero interest rate policy era as it embarked upon a 25 basis point increase – the first hike since 2006. At the time of the December 2015 rate decision, the Federal Reserve had indicated that there would probably be four more quarter point increases during the course of 2016.

Over the past two weeks, both the ECB and the US Fed held their customary monetary policy meetings. As I explained in detail in last week’s article, on 10 March the ECB announced a comprehensive set of measures to address persistently low inflation and weak economic growth. Some of these measures had been widely expected while others came as a surprise to many analysts. More importantly for the currency markets was the statement made by the ECB President Mr. Mario Draghi that it would be unlikely for interest rates to fall further. In fact, notwithstanding the scale of monetary stimulus that exceeded expectations which initially led to an immediate weakening of the Euro against the USD from around USD1.10 to USD1.08 within minutes after the ECB decision, the cautious tone of Mr Draghi on future interest rate cuts caused a jump in the EUR/USD rate to USD1.12 very soon afterwards.

Meanwhile, last week, the US central bank drastically scaled back its interest rate projections and now foresees just two additional hikes of 25 basis points each in 2016. The Federal Reserve’s more cautious stance came despite a positive assessment of the US economy with a pick-up in inflation, a strengthening of the labour market and moderate economic growth despite the challenging circumstances across the globe. However, the US Central Bank again remarked that global developments “continue to pose risks” and that “inflation is expected to remain low in the near term”, before rising to its 2 per cent target.

The shift in expectations by the Federal Reserve immediately led to a sell-off of the US Dollar last week as it breached USD1.13 against the euro, its lowest level in a number of weeks.

The main argument that was being made a few months ago in favour of continued strengthening of the US Dollar against the Euro was the monetary policy divergence between two of the major global central banks. The interest rate cuts and additional stimulus by the ECB as opposed to a series of interest rate increases in the US was widely expected to lead to a lower EUR/USD rate.

So why has the Euro strengthened against the US Dollar since the start of the year? Although Central Bank policies are in fact diverging, as the ECB did indeed cut interest rates and the Fed is still intent on raising rates, more importantly, however, is that we are witnessing a convergence of market expectations.

The statement by the ECB President Mario Draghi on future rate cuts lowered the probability of reduced interest rates across the eurozone going forward. Similarly, the more cautious tone from Fed chairperson Janet Yellen on future rate increases lowered the probability of multiple interest rate increases in the coming months. At the start of the year, the market was expecting the Fed to be more aggressive with its outlook on rate hikes, while the comment by the ECB President on the low probability of additional interest rate cuts impacted expectations. Due to the latest remarks by the chiefs of two of the major central banks, interest rate expectations are in fact actually converging towards less aggressiveness on both paths.

Despite this sudden change in expectations, exchange rate volatility is likely to persist in the coming months. The major factors influencing currency movements will continue to be future decisions and statements by both the ECB and the Fed. Moreover, the publication of economic data will also play a key role as this may also led to a change in market expectations.

Some international financial analysts continue to predict that the USD will strengthen and will breach the parity level against the euro by the end of 2016. These analysts claim that inflation will rise much quicker than expected forcing the Federal Reserve to adopt additional hikes apart from the two rate increases being projected.

On the other hand, other analysts forecast that the USD will continue to weaken against the euro with the EUR/USD exchange rate at the end of this year rising to a high of USD1.20 as the Fed remains uncertain on US economic activity as a result of global economic and financial market developments.

It is becoming increasingly difficult to predict how future developments will affect the value of the US Dollar and the Euro. What is certain however is that high volatility is expected to continue to characterize the currency markets until the end of 2016 and beyond. Although the underlying economic fundamentals are always very important gauges, changes in market expectations are likely to have an even larger impact.

Amid expectations of continued currency volatility, investors must be aware that this may have wide implications on the performance of their investment portfolios if they have considerable exposure to the US Dollar. Investors should therefore monitor developments closely and reconsider whether such foreign currency exposure is justified in the light of their overall investment objectives and their risk profile.

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