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27.12.2013 admin
The end result is that European monetary policy outlook remains especially uncertain, and such uncertainty has helped keep the Euro in a wide trading range against the US Dollar. Danske Bank's latest exchange rate forecasts for 2014 suggest the British pound (GBP) can look forward to further gains ahead against the Euro. The British pound (GBP) is forecasted to maintain an upward trajectory against the Euro, this is according to analysts at Danske Bank who see the pound to euro exchange rate trading at 1.25 by the end of their 2014 forecast period.
The strong numbers in the UK makes it increasingly likely that the BoE might have to hike rates this year adding further to GBP support.
Economic activity has been strong and the unemployment rate has dropped significantly over the past couple of months. The Bank of England (BoE) has said it will not consider tightening policy, at least until the unemployment rate falls to 7%. Economists’ best guess for the dollar’s value tomorrow is its value today, but they predict exchange rates a decade into the future. A simple (and snarky) answer would be that any prediction about exchange rates will eventually come true if you wait long enough – if the euro-dollar exchange rate is a random walk, then sometime in the future there will be a period during which the dollar declines.
For example, consider the euro-dollar exchange rate’s behaviour in response to US monetary decisions since the beginning of the subprime crisis. On 18 March 2008, the FOMC again cut the Fed Funds rate, from 3 to 2 ? percent.2 Markets anticipated this move, so the dollar depreciated prior to the meeting. Note that a convergence of demographic structures and development levels across countries translates into a convergence in NFA-to-GDP ratios in the “very long run”. Danske Bank have issued a foreign exchange rate forecast update which follows the broader market theme for a weakening euro and appreciating US dollar in 2014. However, this is not the full story; analysts have warned that they are upping their near-term euro forecasts as they predict the European Central Bank (ECB) will not readily jump into a round of fresh easing. Economic data has lost some steam in the US recently, whereas eurozone data has surprised on the upside.
The eurozone current account surplus continues to rise, while the US is stuck with a deficit. Overnight Index Swaps suggest that the Euro will most likely maintain its interest rate advantage over the US dollar, but headline yields hardly paint the entire picture.
Although EURUSD has seen decisive gains on the back of a rebound in risk appetite beginning in early March, the long-term fundamental picture is supportive of a broadly bearish scenario: a smaller-scale fiscal effort and a deliberately slow approach to monetary easing suggest the Euro Zone's economic recovery will lag behind that of the US, fueling expectations that the Fed will be first to raise interest rates and boost demand for greenback. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate.


However, in the November Inflation Report, it moved its forecast for this threshold to be met from Q3 16 to Q3 15.
On the other hand, we expect the ECB easing bias and a cut in the deposit rate to negative to weigh on the EUR in 2014. This column explains the difference between short-run and long-run exchange rate forecasts and examines the future of the euro-dollar rate. There are good reasons for the difference in our ability to forecast exchange rates in the short run and the long run. Forecasts delivered by macroeconomic exchange-rate models are generally found to be less accurate than the random walk, i.e. In the standard exchange rate model, a 75 point cut in the Federal Funds rate should trigger a larger depreciation of the dollar than a 50 point cut.
The reason is that, paradoxically, it is less difficult to predict long-run than short-run evolutions, because long-run trends are cleaned up from noise and bubbles that are especially difficult to model, and because no exact timing is asked for when looking at “long run” forecasts. In the “very long run”, the real exchange rate (the relative price of the same basket of goods across two countries) is expected to come back to a constant level, due to the convergence of the prices of both traded goods (due to international arbitrage) and non-traded goods (due to productivity equalisation all over the world).
Since all NFA positions should sum to zero worldwide, this means that NFA ratios as well as trade accounts are balanced in the very long run, which is consistent with purchasing power parity.
In recent work (Benassy-Quere, Bereau and Mignon (2008)), we argue that the euro and the dollar both seem overvalued against trade-weighted basket of currencies based on any of the three definitions of the long run. The development of international securities denominated Asian currencies is a pre-condition for international markets to stop considering the euro as the only alternative to a weakened dollar. The February FX forecast has added to this theme with the bank saying the risk to their view is to the upside. We expect the US to grow decisively this year but see more potential for positive euro-zone surprises.
This should set the scene for a cyclical USD uptrend, as the Fed will be looking to hike rates way ahead of its eurozone counterpart. The combination of the ECB’s OMT programme and the eurozone escaping recession should help attract capital again and support the EUR, ceteris paribus.
Soft growth numbers and almost-negligible inflation readings arguably give European officials leeway in taking aggressive measures to boost money supply. However, note that the money market has already priced in that the first rate hike will take place in early 2015.
During the days preceding the FOMC meeting, the dollar had depreciated sharply against the euro because markets already expected a monetary easing and hence a fall in the return to dollar assets.


Based on the standard portfolio-choice theory of exchange-rate determination, the dollar should have depreciated after the meeting because of the lower remuneration on dollar-denominated assets.
But the exchange rate depends upon unobserved market expectations, which are difficult to capture in these models, as illustrated above.
At least, market economists, surveyed by Consensus Forecasts in London, increasingly expected that the dollar would depreciate against other currencies, including the euro. The trade account must be positive if the NFA ratio is negative, to compensate for net interest payments to the rest of the world and keep the NFA ratio constant. With relatively large adjustments needed and limited sensitivity of trade flows to relative prices, large exchange rate adjustments are expected to take place in the “medium-long run”. By triggering faster appreciation of Asian currencies, this may speed up NFA adjustments and reduce the cost of the rise and fall for the Euro area. Mignon (2008), “Equilibrium Exchange Rates: a Guidebook for the Euro-Dollar Rate”, CEPII working paper 2008-02, March. The ECB is keeping its options open and a deposit rate cut in response to lower-than-expected inflation is set to underline monetary-policy divergence. Since a positive trade account requires a weak currency, a negative NFA ratio is associated with a weak currency in the “long run”.
When the NFA-to-GDP ratio has converged to its equilibrium value, the current account no longer needs to be different from zero and the “long run” value is then reached. Some members suggest that interest rates may well go below 1.00 percent and special measures are imminent, but others see far less urgency in taking drastic action. We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar.
The BoE might try to correct this pricing, saying that that rate will not be hiked this early. However, in the long and very-long run, the equilibrium value of the euro is found much lower – around 1.10.



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