Unless there is an unexpected economic shock between now and mid-December, the US Federal Reserve will in all likelihood raise interest rates at the meeting of the Federal Open Market Committee on December 15 and 16, marking the first increase in nine years.
With the markets unwinding their positioning for a monetary tightening next March, the US dollar’s rally looks capable of extending into the end of the year, especially as expectations for other major central banks are becoming more dovish. In fact the extent to which the dollar does gain ground may depend as much on the actions of other central banks, especially the European Central Bank, which is moving towards easing monetary policy again next month.
The markets are starting to expect some concrete easing steps to be taken by the European Central Bank as early as the council meeting on December 3. This meeting is now shaping up to be one of the most pivotal events between now and the year -end, now that a Fed rate hike looks more of a done deal following strong US jobs data in October. After the ECB’s council meeting on October 22, Mario Draghi, the ECB’s president, said it stood ready to adjust its monetary policy at the meeting in December, given the downside risks to euro-zone growth and inflation.
His remarks were unusually specific and clearly led the markets to expect additional easing measures to be taken. Since then, however, the euro has declined and that has intensified as expectations of US monetary policy tightening have also gained ground. To some this may have alleviated the urgency for the ECB to act because a weaker currency already provides a degree of monetary stimulus, and subsequent comments from a number of ECB officials have struck a note of caution about whether or not the ECB will actually deliver.
Still, markets are imagining potential outcomes from the ECB’s meeting in December, including raising the amount of monthly asset purchases from €60 billion to €80bn, and the extension of these quantitative easing purchases beyond next September. There is also a focus on the deposit facility, with increasing chatter that deposit rates could be cut from minus 20 basis points further into negative territory. By charging more for deposits this should encourage banks to lend more into the domestic economy, and also to look for more attractive assets overseas. In effect one of the lowest interest rates in the world would further dissuade local investors from parking their money in euro-zone banks, and increase the euro’s role as a funding currency when it comes to foreign investors looking for attractive yields.
The net effect should be euro-negative, especially against the dollar, which will be buoyed by higher US interest rates, not only in December but progressively through next year as interest rates continue to rise. Furthermore, Mr Draghi has continued to repeat his economic concerns, saying in the past week that economic risks were “clearly visible” and inflation dynamics had “somewhat weakened”.
By ECB standards this was a fairly unambiguous message, especially in light of recent doubts over whether the ECB would have the nerve to act. And by making such comments with the euro already lower, at 1.07, and not 1.14 where it was in October, they also show that it is not just about the exchange rate, motivated by the desire to bring the euro down from the year’s highs.
Having started the year under pressure, the euro recovered going into the summer as doubts about Fed tightening prospects caused the dollar to lose ground and as risk aversion took hold, with euro-dollar rising from 1.05 in March to 1.15 in August. However, most of those gains have dissolved in the space of a month as the Fed has become more committed to tightening while the ECB simultaneously became more dovish.
From where it currently stands, it would not take much for the euro-dollar to retest the lows of the year. And should the ECB ease monetary policy further in December, as it has hinted, and the Fed tightens a week later, it is not beyond the realms of possibility that parity could be tested much sooner than many in the markets think as well.
Tim Fox is head of research and chief economist at Emirates NBD.
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