Optimism Surrounding the Dollar as 2014 Kicks Off: What Does Such Mean?

January 9, 2014

For a variety of reasons, forecasters seem more bullish than bearish about the dollar’s prospects this year.  Optimism not only stems from the theoretical soundness of pro-dollar factors but from their number.  Even if some potential dollar boosters fail to activate, it seems less than likely that such will be the case with all of them.

  • The dollar got off to a good start and at this writing shows gains of 2.4% against the Canadian currency, 1.9% versus the Swiss franc, 1.3% relative to the euro, 0.6% against sterling and 0.4% vis-a-vis the Australian dollar.  One robin doesn’t make a spring, but it’s best to start off on the right foot.
  • Fed tapering has begun.  Many pundits believe the Fed may be underestimating the evolution of GDP growth and inflation in 2014.  If so, a data-driven policy would shift gears away from accommodation more quickly than the Fed’s own forward guidance suggests.
  • Lessening U.S. reliance on imported energy has broadly positive implications for the dollar.  One of these is a smaller U.S. current account deficit.
  • The Federal U.S. budget deficit and U.S. jobless rate have fallen more sharply than anticipated and should remain on downward trends.
  • A hidden agenda of Abenomics is a depreciating yen.  Japan’s trade deficit has not yet shrunken as much as hoped.  Japan’s sales tax hike in April needs to be counter-balanced by growth stimulants, including a new down-leg of Japan’s exchange rate.
  • ECB policymakers are relying on forward guidance more than true monetary stimulus.  They have tolerated a very slow economic recovery, near-term inflation that’s running far below target, and a resilient euro.  Such foot-dragging puts the region’s upswing at risk and maintains the danger that better financial market conditions may not continue.  A weak and fragmented regional economy perpetuates the danger that the euro breaks apart sometime.
  • Fed tapering poses a threat of capital flight out of emerging economies, especially ones saddled with sizable current account deficits.

It’s not an accident that the dollar and other key currency relationships so consistently defy conventional wisdom.  A dynamic of foreign exchange is that unexpected developments tend to trump factors known well in advance.  Actual currency movements are frequently counter-intuitive as a result.

Note should also be made that dollar optimism has often surfaced in January.  For one thing, there’s a seasonal bias for the dollar to appreciate against the euro in the first half of the month.  The largest such gains over the past decade amounted to 6.4% in 2009, 3.7% in 2005, 2.3% in 2012, and 2.0% in 2007.  A common motif in recent years, moreover, has been the view that U.S. economic growth was poised to strengthen in the coming year, and while it often did in the early months, getting through the middle of the calendar year has proven more problematic.

The dollar was stronger against the euro and yen before the financial crisis and Great Recession.  Some pundits have used this fact to argue that the dollar is now overdue for a breakthrough year on the upside because big shifts in the currency tend to run in seven-year cycles.  That being said, it will indeed take a significant and broad upturn of the dollar to establish a new configuration.  The table below of calendar year dollar averages since 2008 against the euro and yen shows a whole different trading range in each year from the U.S. currency’s ranges during the nine years after the birth of the euro to end-2007. 

period averages Dollars per Euro Yen per Dollar
1999-2002 0.9575 117.06
2003-2007 1.2495 113.65
2008 1.4707 103.32
2009 1.3942 93.61
2010 1.3258 87.67
2011 1.3923 79.73
2012 1.2869 79.82
2013 1.3281 97.60

Especially in the case of the euro, but also for the yen, a stronger contrast exists between pre-crisis and post-crisis than between sequential years since 2008, and the lasting impression is that the global financial crisis of 2007-08 and ensuing Great Recession spawned negative dollar factors that transcend the monetary policy cycles that occurred over the past half dozen years.  In the latter regard, the U.S.-German ten-year bond spread of 109 basis points is little different from the differential of 99 basis points six months ago.  True, it’s three times wider than the spread of 38 bps a year ago, but that differential was similar to the average of 47 basis points in 1999-02 when the dollar was much stronger against the euro than now. 

One thing changed by the crisis is that potential U.S. GDP growth has dropped considerably.  Inflation scolds indeed use that fact to criticize Fed policy for being too accommodative.  Yes, unemployment is higher than it was historically, and true, too, real growth is lower.  However, critics maintain that it will take much less real economic growth in the future to correspond to the target inflation rate than used to be the case.   Another notable change is the greatly accelerated inequality of income and wealth in the United States, which will have negative consequences for economic growth 3, 5 or more than 10 years from now.  And a third problem concerns the toxic effect that America’s economic difficulties since 2007 have had on policymaking.  Infrastructure is being neglected, and advantages that fed the U.S. lead in productivity growth for over a century — superior education and immigration incentives — have been casualties of the current push to cut government at whatever cost and to insulate the country from the rest of the world. 

The dollar in one fundamental sense captures the present value of America’s outlook as an economic and geopolitical power.  Against the postwar rubble that was Japan and Europe in the late 1940s, U.S. hegemony was nearly absolute and unchallenged, and it showed in dollar exchange rates that made the U.S. currency much more expensive than now.  In spite of clear demographic advantages enjoyed by the United States, the EUR/USD and USD/JPY relationships do not tell a story of a much better outlook in America.  For reasons enumerated at the start of this essay, 2014 seemingly offers several reasons to become a breakout year for the dollar.  If the dollar nonetheless fails to strut its stuff, such a result will tell investors a lot more about the medium term prognosis than about short-term developments in 2014.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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