During the course of 2015, one of the most talked-about themes across international financial markets was the strength of the US dollar against most currencies, especially the euro. The dollar streng­thened by 10.2 per cent during 2015 from a rate of $1.21 per €1 in January to a year-end level of $1.086.

Some international economists and financial analysts were even projecting that the exchange rate would reach parity, i.e. the value of one euro would be equivalent to $1.

However, since the start of 2016, we have so far witnessed a movement in the opposite direction. In fact, the dollar has weakened by over 3.7 per cent against the euro, from a EUR/USD rate of around $1.085 at the start of the year to $1.13 last week.

Since currencies are valued against one another, the performance of a currency signifies relative strength or weakness against another currency. In this case, the movement of the EUR v USD exchange rate is dependent on factors affecting the US economy as well as developments across the eurozone, and more importantly the monetary policy decisions and expectations by the Federal Reserve and the European Central Bank (ECB).

Until a few months ago, general expectations were that the dollar would continue to strengthen against the euro driven by monetary policy divergence. The US Federal Reserve (Fed) was expected to raise interest rates while the ECB would, on the other hand, continue to increase its dose of monetary stimulus, thereby leading to a weaker euro.

In December 2015, the US central bank brought to an end the zero interest rate policy era as it embarked upon a 25 basis point increase – the first hike since 2006. At the time of the December 2015 rate decision, the Federal Reserve had indicated that there would probably be four more quarter point increases during the course of 2016.

The dollar has weakened by over 3.7 per cent against the euro, from a EUR/USD rate of around $1.085 at the start of the year to $1.13 last week

Over the past two weeks, both the ECB and the US Fed held their customary monetary policy meetings. As I explained in detail in last week’s article, on March 10 the ECB announced a comprehensive set of measures to address persistently low inflation and weak economic growth. Some of these measures had been widely expected while others came as a surprise to many analysts. More importantly for the currency markets was the statement made by the ECB president Mario Draghi that it would be unlikely for interest rates to fall further. In fact, notwithstanding the scale of monetary stimulus that exceeded expectations which initially led to an immediate weakening of the euro against the dollar from around $1.10 to $1.08 within minutes after the ECB decision, the cautious tone of Mr Draghi on future interest rate cuts caused a jump in the EUR/USD rate to $1.12 very soon afterwards.

Meanwhile, last week, the US central bank drastically scaled back its interest rate projections and now foresees just two additional hikes of 25 basis points each in 2016. The Federal Reserve’s more cautious stance came despite a positive assessment of the US economy with a pick-up in inflation, a strengthening of the labour market and moderate economic growth despite the challenging circumstances across the globe. However, the US Central Bank again remarked that global developments “continue to pose risks” and that “inflation is expected to remain low in the near term”, before rising to its two per cent target.

The shift in expectations by the Federal Reserve immediately led to a sell-off of the dollar last week as it breached $1.13 against the euro, its lowest level in a number of weeks.

The main argument that was being made a few months ago in favour of continued strengthening of the dollar against the euro was the monetary policy divergence between two of the major global central banks. The interest rate cuts and additional stimulus by the ECB as opposed to a series of interest rate increases in the US was widely expected to lead to a lower EUR/USD rate.

So why has the euro strengthened against the dollar since the start of the year? Although Central Bank policies are in fact diverging, as the ECB did indeed cut interest rates and the Fed is still intent on raising rates, more importantly, however, is that we are witnessing a convergence of market expectations.

The statement by Mr Draghi on future rate cuts lowered the probability of reduced interest rates across the eurozone going forward. Similarly, the more cautious tone from Fed chairperson Janet Yellen on future rate increases lowered the probability of multiple interest rate increases in the coming months. At the start of the year, the market was expecting the Fed to be more aggressive with its outlook on rate hikes, while the comment by the ECB president on the low probability of additional interest rate cuts impacted expectations. Due to the latest remarks by the chiefs of two of the major central banks, interest rate expectations are in fact actually converging towards less aggressiveness on both paths.

Despite this sudden change in expectations, exchange rate volatility is likely to persist in the coming months. The major factors influencing currency movements will continue to be future decisions and statements by both the ECB and the Fed. Moreover, the publication of economic data will also play a key role as this may also lead to a change in market expectations.

Some international financial analysts continue to predict that the USD will strengthen and will breach the parity level against the euro by the end of 2016. These analysts claim that inflation will rise much quicker than expected forcing the Federal Reserve to adopt additional hikes apart from the two rate increases being projected.

The shift in expectations by the Federal Reserve immediately led to a sell-off of the dollar last week as it breached $1.13 against the euro, its lowest level in a number of weeks

On the other hand, other analysts forecast that the dollar will continue to weaken against the euro with the EUR/USD exchange rate at the end of this year rising to a high of $1.20 as the Fed remains uncertain on US economic activity as a result of global economic and financial market developments.

It is becoming increasingly difficult to predict how future developments will affect the value of the dollar and the euro. What is certain, however, is that high volatility is expected to continue to characterise the currency markets until the end of 2016 and beyond. Although the underlying economic fundamentals are always very important gauges, changes in market expectations are likely to have an even larger impact.

Amid expectations of continued currency volatility, investors must be aware that this may have wide implications on the performance of their investment portfolios if they have considerable exposure to the dollar. Investors should therefore monitor developments closely and reconsider whether such foreign currency exposure is justified in the light of their overall investment objectives and their risk profile.

Edward Rizzo is a director at Rizzo, Farrugia & Co (Stockbrokers) Limited.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd (RFC) is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the company/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent, and may also have other business relationships with the company/s. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.

© 2016 Rizzo, Farrugia & Co. (Stockbrokers) Ltd. All rights reserved.

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