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US and UK rate hikes to drive euro further south

The euro has lost considerable ground since last spring as the persistence of very weak growth in the eurozone, coupled with a fall in inflation to very low levels, forced the ECB into further policy easing moves.

It has also become increasingly clear that while interest rates are likely to rise, albeit modestly, in the US and UK over the next couple of years, they are set to remain pegged at virtually zero in the eurozone for a prolonged period.

The euro fell from $ 1.40 last May to close on $ 1.20 by the end of 2014. Against sterling, it declined from a high of 84p in early 2014 to 78p at the end of the year. These trends continued in the opening weeks of 2015, with euro weakness gathering momentum on the back of the ECB announcement of a full-blown QE programme.

The currency is down around 5% against both the dollar and sterling since the start of the year. It fell through critical support levels near $ 1.18 against the dollar and is now trading at around $ 1.14. Against sterling, it has fallen below 74p after major support at 78p gave way.

Another noticeable feature of FX markets in early 2015 has been increased volatility, in part, related to central bank policy changes. The Swiss National Bank caught markets completely off guard with the shock decision to discontinue its policy of capping the franc’s exchange rate against the euro, resulting in a sharp appreciation of the currency.

Meanwhile, surprise easing announcements from Central Banks, such as the Bank of Canada, Reserve Bank of Australia and the Swedish Riksbank, have resulted in weakness for their currencies. The euro has also been volatile enough, recently. It fell to as low as $ 1.11 in January, before edging back to trade in a $ 1.13-$ 1.15 range recently. The uncertainties about Greece, negative eurozone inflation, and QE have all been negative factors weighing the single currency.

Changes in expectations about when we will start to get rate hikes in the US and UK have also been impacting markets, which have become particularly sensitive about labour market data in both economies. In our view, if expectations for a US rate hike by around mid-year prove correct, then the dollar is likely to continue to move higher.

Important upcoming events in this regard are Federal Reserve chairwoman Janet Yellen’s bi-annual testimony to Congress this week and the next Fed policy meeting in mid-March. The expectation is that the Fed may signal that a rise in US interest rates is increasingly likely at one of these events.

The euro-dollar rate could test support levels at around $ 1.10-$ 1.11 before the end of March on any Fed tightening signals. It could then move lower to around the $ 1.05 level later in the year, if US rate hikes materialise. With the Fed expected to raise rates by mid-2015, pushing the dollar higher, sterling traders will face an interesting question: Should sterling also continue to move higher against the euro? In our view, US rate hikes would strengthen the view that UK rates will also have to eventually rise.

If expectations of even modest rate hikes in the UK remain intact, the currency should appreciate further against the euro. Hence, we see the euro-sterling rate heading towards 70p over the course of 2015. We expect sterling to remain fairly stable against the dollar at close to $ 1.50. An important risk to bear in mind for sterling, though, is a result in the UK general election that markets view as negative for the currency. The outcome of the election is unclear. It could result in an unstable, minority government. It is also unclear whether there will be a referendum on the UK’s continued membership of the EU. These issues have the capacity to cast a cloud over sterling this year.

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