Dollar surge: Just how much stronger will the currency get?

Will careful words from the Fed add fuel to the dollar rally?

The US Fed meeting this week will have big implications

Yesterday saw some respite for those worrying about a surging dollar, as the euro rose just under 1 per cent to the $1.05 mark. But this did little to change the wider picture. Partly driven by divergent monetary policy paths in the US and the Eurozone (the Fed is expected to raise interest rates this year, while the European Central Bank has just launched a €1.1 trillion quantitative easing programme), some are now expecting the euro to reach parity with the dollar in just a few trading sessions. But the greenback has not just strengthened against the single currency. On Friday, it reached a 11-year high against a basket of 10 major currencies grouped by the Bloomberg Dollar Spot Index (see chart). And regardless of yesterday’s interlude, analysts agree that there is still more to come. But just how much stronger can the dollar get?

EURO-DOLLAR PARITY: A MATTER OF TIME?

As a source of stability in international markets – and whatever the problems it might cause US exporters– the dollar is expected to keep rising this year: “The excessively low interest rates in Japan and Europe mean investors are piling out of these markets and into dollar-denominated assets,” says Bill Blain, market commentator and strategist at Mint Partners.
And this move is expected to be strongest against the euro. While revising its three, six, and 12 month forecasts for euro-dollar to $1.02, $1.00 and $0.95, a Goldman Sachs note from last Friday forecast that the euro could sink to just $0.80 by the end of 2017. A combination of stronger growth and tighter monetary policy in the US and slower growth and looser monetary policy in the Eurozone means that the current exchange rate “just isn’t stretched,” the note’s author said.
But much is contingent on what US monetary authorities do next. The Fed meets this week and, after a two-day meeting, will announce its latest policy decision on Wednesday. Markets are expecting an update on the next steps the central bank will take towards raising interest rates.
Based on Fed chair Janet Yellen’s previous comments, a withdrawal of the pledge to be “patient” on raising its benchmark rate would remove the two-month buffer leading to the first rate hike, says Oanda market analyst Craig Erlam. And if this does happen, “this could bring about one more push in the dollar before the long overdue correction, and a rather sizeable one at that”, he says. Yet sentiment is divided on the prospect of a snapback. Head of research at FxPro Angus Campbell only sees a limited chance of an upside for the single European currency, and “parity doesn’t look too far away” to him.

A DOLLAR-LED RALLY IN EQUITIES

Besides reading the runes at the Fed, investors could watch equity markets – including those in Europe – for an indication of the greenback’s trajectory.
European markets picked up yesterday, with a weaker euro seen as benefitting Eurozone companies. A plunging euro makes European firms more competitive abroad, as their products and services become relatively less expensive. And it also helps non-exporters, as they compete with firms selling into the currency bloc. The Wall Street Journal’s March survey of 63 economic forecasters showed 55 per cent of respondents citing a stronger dollar as the top reason for the US’s widening trade gap.
A weak euro is adding to the confidence and momentum quantitative easing has given European bourses, says David Buik of Panmure Gordon. “Many of these stocks should be very attractive to investors, who have the ability to either benefit from a weak euro or the ability to capitalise on hedging. Selected stocks in Italy and Spain could benefit in a similar manner”, he says.
The industrial and export-heavy Dax index in Germany, for example, rose 1.8 per cent yesterday. The index has risen over 22 per cent since the beginning of the year, and broke the 12,000 mark for the first time ever on Monday.

MORE WINNERS AND LOSERS

While sterling has followed the dollar in strengthening against the euro over the past few months, the greenback’s surge has not passed the pound by. Over the past three months, sterling-dollar has fallen from $1.56 to $1.48, a decline of about 5 per cent. And the pound has weakened less significantly against the euro than the dollar has. “The sterling exchange rate against the euro is down only 8 per cent in 2015 as compared to the 13 per cent decline in the euro-dollar exchange rate,” says Campbell.
While many lump the UK with the US among those countries about to normalise monetary policy, despite the UK’s strong and consistent growth, “Bank of England governor Mark Carney has recently taken an unexpectedly dovish stance towards future rate hikes and this has taken the wind out of sterling’s sails,” adds Campbell.
And with the General Election fast approaching, analysts are expecting sterling volatility to pick up sharply. “As we’ve seen in every election since 1983, levels of volatility for sterling can reach up to 156 per cent,” says Mark Bodega, director at HiFX.
It may not just be sterling that faces volatility over the next few months – the dollar itself may not be immune. According to Steven Englander of CitiFX, the dollar’s rally over the past eight months has been its fastest in at least 40 years. Some are concerned that such a sharp rise will hit inflation in the US – already a key concern for the Fed. And if Yellen decides to factor that into her calculations, the Federal Open Market Committee’s meeting this week may even put the brakes on the dollar’s astonishing rally.

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