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…crucially Dr Yellen also said that rates were close to the Fed’s neutral policy level and may not need to rise much more.

At the beginning of January the EURUSD hit its lowest level against the dollar in fourteen years. Yet ten days ago the pair hit its highest intra-day high since the first trading day of 2015. This represented a remarkable recovery for the euro over the year to date.

The turnaround has come about for a variety of reasons. Firstly, the euro was looking oversold after coming under downward pressure in the last two months of 2016. The dollar was in demand following Donald Trump’s surprise victory in the presidential election last November. Investors bought dollars on the expectation of a “business-friendly” administration which would usher in lower taxes, large dollops of infrastructure spending and a reduction in regulations. None of that has come to pass so far, although there was some optimism last week after President Trump appeared to strike a deal with his Democratic opponents. In addition, hopes have been raised that major tax reform could still be on the cards along with a (temporary) resolution to the issue of the debt ceiling.

Technically the EURUSD bounced back from an oversold position after failing to break below parity for the third time since early 2015. But there were other reasons for the euro rally and the dollar’s decline. Principally we’re looking at the change in expectations when it comes to considering the possible actions of central bankers. The US Federal Reserve began to tighten monetary policy even as the ECB continued with a €60 billion per month bond purchase programme. This in itself should be enough to support the dollar and undermine the euro. But expectations are everything. Investors have been speculating what the ECB will do as their current bond purchase programme is set to run to the end of this year. The feeling is that the central bank will start to wind down its stimulus and this is helping to support the single currency.

But perhaps the most important issue here is the shift in attitudes at the Fed. At the beginning of the year the US central bank gave every indication that it would push ahead with monetary tightening, irrespective of a turn-down in inflation or weakness in economic data. Many analysts believed that the Fed was desperate to “normalise” rates so that they would have room to cut when the next recession hit. However, this view changed following Janet Yellen’s testimony in Washington in July. She said that the Fed was watching inflation closely, implying that it should be much closer to its 2% target before tightening further. But crucially Dr Yellen also said that rates were close to the Fed’s neutral policy level and may not need to rise much more. This led commentators to revise down their upper target for fed funds to 1.75-2.00% from around 3.00% previously. This is one of the reasons why commentators no longer expect the Fed to hike rates again this year.

The upward trend in the EURUSD remains in place as can be seen clearly in the chart below. However, where we go from here has much to do with what happens at the Fed meeting on Wednesday. The expectation is that the US central bank will lay down a timetable for reducing its $4.5 trillion balance sheet. This in itself is something that’s never been attempted before so the Fed has to get this right. All the indications suggest that this will be carried out at a glacial pace. But if the market feels the Fed is set to remove stimulus too quickly, then the dollar could turn sharply higher.

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Posted by David Morrison

Category: PM Bulletin


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