Don’t Count on Across-the-Board Dollar Strength from Reduced Fed Asset Purchases

December 12, 2013

The Fed has floated several “tapering” balloons since last spring.  The eventuality of lessening quantitative monetary stimulus has been on the table for over seven months, plenty enough to become a fact of investment life.  If the dollar were to have benefited sharply or across the board from this possibility, it would surely have happened.  Since the Bernanke speech suggesting a taper on May 22, the dollar has instead declined by over 6% against the euro, around 8% against sterling and some 9% relative to the Swiss franc.  The dollar has advanced about 8% against the Australian dollar under relentless protest by Aussie monetary officials about their money’s excessive value, and it has strengthened about 3% versus the loonie.  But the greenback is softer against the kiwi, which has been supported by the prospect of a New Zealand central bank hike perhaps early in 2014.

In the wake of an aborted start to tapering in September, March had seemed to be the likeliest timing.  That said, I would not be surprised if officials changed settings at next week’s meeting.  Growth in U.S. jobs recently improved though not dramatically so, and long-dated Treasury yields have not climbed above their early September highs.  I also don’t think the timing of the first taper will matter that much for the dollar.  A disconnection has been better established in market psychology between the wind-down of the asset purchase program and the intention to keep the federal funds rate pinned near zero for a considerably additional span of time.  The yield curve will provide monetary officials with constant feedback about how strongly investors continue to understand that distinction. Should the curve’s steepness exceed what officials desire or should indicators of U.S. production and demand struggle excessively during the tapering wind-down, the process will likely be paused, reversed, or countered with verbal guidance or countervailing monetary policy changes.

One has to be very careful about underestimating the impact on currency markets of monetary policy reversals.  The dollar was profoundly lifted when the Volcker-led Fed began targeting monetary growth.  Contrary to what present Fed officials argue, many private economists including me believe that a lessening of quantitative stimulus constitutes a lessening of policy accommodation, but here’s an important distinction from the 1979-82 with direct implications for currency markets.  The Volcker team desired and expected high nominal and real interest rates to ensue in both short and long maturities.  The Bernanke/Yellen team is intent on anchoring the short end near zero and limiting the speed and extent of the influence on longer maturities.  The problem to attack in Volcker’s day was inflation by whatever means and particularly through a severe policy-induced recession.  The main problem today is insufficient aggregate demand and too little inflation, not too much.  A strengthening dollar in the early 1980s promoted the policy priorities back then.  A strengthening dollar now could heighten deflationary risks and would impede desired rebalancing of demand.

Deflation is a bigger danger in Europe than North America, so much so that the yen’s experience in the nineties and noughties is instructive.  Until the launch of Abenomics this year, the yen’s path of least resistance was toward strength even though GDP grew abysmally.  The politicians of Europe are stubbornly committed to preserving the currency union for largely reasons of geopolitical policy and in spite of enormous economic suffering.  Time and again, a deal has been fashioned to provide just enough to keep the experiment of a single currency on the rails but not enough to address the core problem of current account imbalances among its members.  Euro resilience translates into dollar softness.

The final half of December tends to be a season of European currency strength.  From 1974 through 1987, the D-mark rose against the dollar 13 of 14 times between December 15th and 31st.  The only exception was 1984, which fell into the final highly speculative portion of the dollar’s multiyear upswing.  The average dollar movement against the mark in the second half of December in 1974-87 was a drop of 1.5%.  More recently, the euro scored rises against the dollar over these weeks in ten of its first fourteen years.  The average dollar drop over those years was 0.9%, although 2012 saw a minuscule dip of just 0.2%.

In terms of activity, the days just before Christmas — and in this case after the reaction to next week’s FOMC decision has run its course — tend to be quieter in the currency markets than the week preceding the end of the calendar year.  Another trend to keep in mind is that dollar softness in late December has been followed by an even more pronounced and repeated pattern of U.S. currency appreciation in early January.  HAPPY HOLIDAYS EVERYONE!

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

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