That might not seem such a leap given the prospect that the Federal Reserve will start to rein in its asset purchase scheme and begin to taper its quantitative easing programme, but there are other reasons to support the view that the dollar is finally going to snap out of its 11-year bear market.
Certainly, 2013 marked a sea change for currency investors, with the FX market finally able to throw off the shackles of risk-on/risk-off currency trading that had dominated price action since the financial crisis.
As David Bloom, head of FX strategy at HSBC, puts it, 2013 was not a year of “black swan” fears, where markets whipped from one crisis to another. Instead, he says, developed markets continued their slow rehabilitation – in the case of Japan and the eurozone with some help from their respective central banks.
“It was of course the year when markets were forced to consider how the world would look without QE3 from the US and the answer, for risk assets and emerging markets, was not initially pleasant,” says Bloom. “Yet for many G10 currencies, 2013 saw us return to a normal carry environment, where FX moves were driven by economic data and the associated expectation for central bank policy; all terribly conventional.
| FX performance in 2013 |
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The prospect of Fed tapering, first mentioned by Fed chairman Ben Bernanke in May, was the catalyst for the main move of the year. The scale of the move, just to the prospect of less aggressive easing, was startling, with those markets, principally in the emerging world, rapidly re-rated.
Indeed, as Bloom points out, the filter for EM FX performance flipped to a balance-of-payments model fixated on current-account deficit vulnerabilities, with carry offering little protection.
Mindful of the threat to the US economic recovery that the outsized market reaction generated, the Fed delayed its tapering threat, helping to calm investors’ nerves by using forward guidance to drive home the message that QE tapering is distinct from any plan to raise interest rates.
The repercussions of potential Fed tapering were not confined to emerging markets, however, with the Australian dollar, Canadian dollar and the Norwegian krone all suffering. Interestingly the yen and the Swiss franc failed to capitalize on the unease among investors, with local factors – the Swiss National Bank’s currency floor and the Bank of Japan’s aggressive QE plans – helping to dampen their haven appeal.
It was sterling and the euro that reaped some of the support that would otherwise have gone to the Swiss franc and the yen.
Indeed, for the first time in years, the euro was not the main talking point in the currency markets as the focus moved away from the eurozone financial crisis.
As the chart above shows, only the Israeli shekel outperformed the euro among the world’s 30 most traded currencies, with the legacy of European Central Bank president Mario Draghi’s 2012 pledge to do “whatever it takes” to support the euro project helping the single currency to shake off uncertainty in Italian politics and a Cyprus bailout, not to mention two ECB rate cuts.
For the year ahead, most analysts believe that the dollar will continue to outperform.
JPMorgan, for example, forecasts that 2014 should be a less dramatic version of 2013 now that markets are accepting how abnormal the current process of US rate normalization continues to be.
The bank believes that if cash rates are more influential on currencies than long-end rates (since cash rates drive carry gains and hedging costs), and if cash rates in the US should not move until late 2015 due to low inflation, dollar gains next year should be more limited in magnitude and scope than in 2013.
According to JPMorgan, the biggest losers next year will be the currencies of G10 countries where central banks would be or could be easing monetary policy – such as the yen, Australian dollar, Swedish krona and euro – and the currencies of EM nations where external balances are poor and financing dependent on bond market inflows – such as the Indonesian rupiah, Malaysian ringgit, Brazilian real, Chilean peso, Turkish lira and South African rand.
In contrast, the bank believes the biggest winners will be the currencies of G10 countries with enough cyclical momentum to lift cash rates – such as the New Zealand dollar –or rate expectations – such as the pound – and currencies of EM countries with stronger external positions – such as the Israeli shekel, Mexican peso, renminbi and Korean won.
That range of outcomes, says JPMorgan, should net small gains of about 3% for the dollar index in 2014.
John Normand, head of FX and international rates strategy at JPMorgan, says the most frequent criticism from clients over his bank’s outlook for 2014 is that all banks are bearish on US treasuries and bullish on the dollar for next year, and that consensus views are rarely right. “The most frequent pushback is that some aspects sound too much like 2013, and others sound too consensus,” he says.
Normand says he has no argument with how widely shared some of his views are among banks and clients, but urges investors to consider two points. “First, market themes don’t always change just because the calendar does,” he says. “Second, there is generally very little appetite for non-consensus views, which may take several months to materialize.”
| Will there be a repeat of the late 1990s? |
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Morgan Stanley, meanwhile, sees reason for a bigger sea change in the currency market. The bank says it sees an increasing number of parallels between the last dollar bull market, which started in spring 1995, and the current environment.
In 1995, EM economies began to show signs of weakness across the board, ranging from Mexico to Thailand, with rising bond yields, which started creeping up globally in 1994, not boding well for countries requiring capital imports. Similarly, in the spring and summer of 2013, bond yields shot up, echoing the events of 1994, and suggesting the impact of rising global funding costs on emerging markets could be substantial.
“Previous cycles showed EM underperformance and dollar outperformance go hand in hand,” says Hans Redeker, head of global FX strategy at Morgan Stanley. “The dollar is still the globe’s preferred reference and issuance currency.”
Crucially, Redeker believes that the Fed will not actually have to raise rates for the dollar to rally.
Indeed, when the dollar rallied from March 1995, the Fed funds rate fell from 6.2% to 4.75% in December 1998. The dollar rally was, in fact, only supported by higher rates from the summer of 1999.
“The notion that dollar strength requires the support of rising rates did not hold in the last bull market,” says Redeker.
He believes markets will seek the best relative returns, and that is why the dollar is likely to stand out in 2014.
Indeed, in 1995 it was relative growth differentials that turned the maturing dollar bear market into a bull market. As is the case today, Redeker notes, it was the breakdown of the EM growth model that led growth differentials to narrow, with US capital outflows turning into inflows.
“In the late 1990s, the growth driver shifted from manufacturing toward high tech, from commodity-intensive toward commodity-light expansion, and from emerging markets to developed markets,” says Redeker. “Now the US is regaining some competitiveness and is emerging as the biggest global energy producer, while the need to increase and replace its low and maturing capital stock could cause the US supply side to be surprisingly strong. We believe related productivity gains should push real yields higher, working in support of the dollar.”
It might, in other words, be worthwhile for currency investors to prepare not just for a year of dollar strength but a new multi-year bull run.