This week saw major announcements from both the Federal Reserve (Fed) and the European Central Bank (ECB). As expected, the Fed hiked the Fed funds rate 25 basis points to a range of 1.75-2.00%, while signaling that they expect to hike rates two more times this year and potentially three times next year against a backdrop of falling unemployment and firming inflation. Meanwhile, the ECB noted it is planning to taper its asset purchase program to a monthly pace of €15 billion in September, conclude the asset purchase program at the end of this year, and leave rates unchanged until at least the summer of 2019.
The question for investors is what this means for the U.S. dollar, and more broadly, the trajectory of global growth. Currencies tend to be driven by interest rate and growth differentials in the short to medium-term, but the current account in the long run. While we believe that the U.S. will continue to run a structural current account deficit that should put downward pressure on the dollar over time, in the shorter term, there seems to be room for the dollar to hold its ground or perhaps even strengthen. We do not expect a repeat of the 2015 experience when the dollar soared, but acknowledge that the path of least resistance may be higher.
While further dollar strength may worry some investors, currencies are the mechanism by which the global economy adjusts. As such, if the euro comes under pressure in the wake of these announcements, it could actually end up being a positive development for the Eurozone economy. Manufacturing and exports account for a larger share of the Eurozone economy than is the case for the U.S., suggesting a weaker euro could help to stimulate economic growth after a particularly soft start to the year. Furthermore, with emerging markets (EM) highly levered to developed market (DM) demand, a resurgence in DM growth could lead to a resynchronization of growth at the global level, allowing risk assets broadly to continue their upward ascent.
Short-term currency movements are driven by rates and growth
EUR/USD y/y % change, growth and interest rate differentials*
Source: Markit, Tullett Prebon, Reuters, FactSet, J.P. Morgan Asset Management.
*Growth and interest rate differentials are an average differential between U.S. and Eurozone PMIs and U.S. and German 10- year government bond yields.