Dollar to climb further against euro and yen

Some commentators have suggested that the prospect of an earlier rate hike from the Fed and the resulting appreciation of the US dollar will significantly reduce the pressure on the ECB and BoJ to ease policy further. However, we think this is wrong on a number of counts.

It is of course true that Fed tightening might achieve part of the aims of additional quantitative easing (QE) in the euro-zone and Japan by weakening the euro and the yen against the dollar. But there are at least four reasons why this is unlikely to negate the need for the ECB and the Bank of Japan to loosen further.

For a start, it is still far from clear that the Fed will begin to raise interest rates any sooner than the markets have been anticipating. While a December move is perhaps now back in play, much will still depend on the US economic data over the next few weeks, as well as developments overseas, notably in China. It would be very risky for central banks in the euro-zone or Japan to rely solely on the Fed in these circumstances, rather than to take control themselves.

Second, the ECB and the BoJ are widely expected to ease further at some point, so this should already be at least partly priced into the markets. If they fail to act, the euro and yen might still appreciate again (or not fall as far as they would otherwise have done) despite higher rates in the US.

Third, even if Fed tightening were to do all of the work in terms of weakening the euro and the yen, this is only one of the ways in which QE might be expected to support growth and reduce the risks of a prolonged period of deflation in the euro-zone and Japan. Others include the direct impact of bond purchases on long-term interest rates, the rebalancing of portfolios towards riskier assets, the impact of an expansion of the monetary base on broader money and credit aggregates, and the impact on inflation expectations.

Fourth, there is the impact on overall confidence. It might not matter for exchange rates whether a given divergence in monetary policies reflects additional tightening on one side or additional loosening on the other, or a combination of the two. However, there would clearly be large differences in terms of the broader impacts, including on investor sentiment and wider business and consumer confidence. Indeed, if the Fed does raise interest rates more aggressively than the markets currently expect, it may be all the more important for other central banks to loosen policy to send a reassuring signal that global monetary conditions will remain accommodative.

"The Bank of Japan maintained its current policy settings on Friday. However, it is still our view that the outlooks for growth and inflation in Japan are both worse than policymakers predict. We are nudging down our end-2015 forecast for the Nikkei from 21,000 to 20,500, but continue to expect the yen to fall to 125 against the dollar by the end of this year and as low as 140 in 2016", says Capital Economics in a research note.

"In the meantime, the euro has already fallen to our previous end-2015 target of $1.10. We are therefore lowering this forecast to $1.05. What's more, we continue to expect the euro to weaken to parity against the dollar - or lower - in 2016, as the economic recovery in the euro-zone disappoints and monetary policies diverge further", added Capital Economics.