In the Year 2015

December 23, 2014

2014 has been a broadly based year of strength for the U.S. dollar, and that can only be said for a minority of time during the past four decades.  Compared to its lows this year of 1.0601/AUD, JPY 101.39, 1.3993/EUR, CHF 0.8696, 0.8677/NZD, 1.7791/GBP, and CAD 1.0583, the U.S. currency is currently up by 30.9% against the Australian dollar, 19.0% against the Japanese yen, 14.9% versus the euro, 13.5% relative to the Swiss franc, 12.6% vis-a-vis the New Zealand dollar, 10.8% against sterling and 9.7% relative to the Canadian dollar.  A number of emerging market currencies, including the Ukraine hryvnia and the Russian ruble, have tumbled considerably more sharply than the above advanced economy currencies.  For reasons discussed in last week’s FX insights essay, 2014 was a banner year for the dollar, and these sources of appreciation didn’t let up in December.  A sample of today’s news captures the dollar’s advantages — U.S. GDP growth in 3Q, panic over the Russian banking system, political developments in Greece that threaten a return of Euroland into a debt crisis, and the patience of the Yellen Fed that is supported by lower-than-desired inflation but not the clear and present danger of deflation that other economies face.

Allow me to digress briefly on applied price theory before turning to 2015, as such is important for understanding why currency markets overshoot.  Students of the dismal science of economics learn that, under significantly simplified assumptions, quantity demanded rises as price falls while quantity offered tends to rise.  These relationships of reactions of quantity supplied and demanded to changes in price can be represented two dimensionally by what appears to be an “X”, whose point of intersection indicates a market price and amount sold that equates what producers will offer with what buyers will pay.  At that market-clearing point, equilibrium is said to occur, and such changes only when something fundamental happens to shift the slope or level of one or both of the so-called demand and supply curves.

In my experience of forty years as a currency market observer, however, equilibrium doesn’t behave so much like a point in foreign exchange as rather a trend of direction.  It takes a threshold of changes to supply or demand to reverse exchange rate direction in an enduring way, although considerable oscillation can occur in tiny to short intervals of time.  Analysts speak often of an economic fundamental being fully priced into the market, but in fact the presumptions, for example, that the FOMC will exert great patience in normalizing monetary policy or that the U.S. economy will experience a more desirable mix of growth and price stability than other economies, do not act as static givens that are fully reflected in price.  Each time evidence corroborates the broad perception of what’s going on, price in fact reacts again even when there hasn’t been any new revelation.  Equilibrium is a movement along a vector of direction, and it takes an accumulation of information that shakes up the conventional wisdom to produce a lasting trend reversal.

With that understanding of the dynamics behind whether the dollar keeps rising in 2015, fluctuates more or less around current levels or turns back downward, it is reasonable to approach the new year by identifying those things that investors are expecting to happen sometime but unsure about timing.  Here’s a sampling:

  • A transformation of the multi-year lackluster trend in U.S. wages into an uptrend that’s observably accelerating.
  • True quantitative stimulus by the European Central Bank with amounts and supporting rhetoric that markets deem credible and likely to steer economic growth upward and away from a deflationary trap.
  • The timing of the first hike in the federal funds rate and whether the ensuing path of policy is sufficiently transparent and perceived well.
  • What happens in Greek politics after December 29 and the extent of contagion if that country takes a turn away from compliance with the monetary union’s rules.  European elections next year in Britain, Germany, the Netherlands, Spain, Portugal and Sweden are also potential Rubicons to be crossed.
  • Will Japanese Prime Minister Abe show the guts and skill to produce long-delayed modifications of labor laws and other needed structural reforms?  How soon will this happen, and how substantial will the actions really be in transforming Japan’s schlerotic system?
  • At what level and when will the price of oil and other falling commodity prices hit bottom?
  • Once the new U.S. congress takes power in January, political gridlock will become more entrenched.  So far, this hasn’t impeded the dollar’s uptrend.  Gridlock is in fact welcomed to the extent that it delivers the short-term certainty of nothing happening.  But one has to be very careful in such inferences.  President Obama is not acting like a short-timer deferring to the other side, and whatever happens will be filtered through the lens of how the all-important 2016 election might be impacted.
  • Might 2015 be the year that sees a bonafide downward correction of the U.S. stock market and/or a cumulating greater-than-anticipated rise in long-term interest rates?  This factor is somewhat less independent from a currency market standpoint than the seven above items.  Because foreign exchange, interest rates and capital flows are in fact determined simultaneously in one giant market stew, they each react to other things including the issues raised above.  That said, the expectations of currency traders are influenced heavily by what is happening to equities and bonds.  Oftentimes, a shift in domestic securities leads a change in foreign exchange relationships.  Other times, the reverse is true. 

The dollar’s fate will march only partly to the beat of unknown resolutions to issues that can be anticipated from the vantage point of December 23, 2014.  The Rumsfeldian unknown unknowns, like Saddam Hussein’s invasion of Kuwait in August 1990 or the September 11, 2001 attacks by Al Qaeda or the magnitude of the market breakdown brought on by a national bear market in housing values last decade.  It’s hard not to think conspiratorially about the halving of oil prices in the second half of 2014.  Some governments have short-term interests and perhaps means in seeing that happen.  From a long-term perspective, this development could be catastrophic if it delays actions needed to avert planet-destroying climate change past the point of no return.  Scientists spoke initially in terms of generations before really bad stuff happens.  That interval has crept in closer.  What if it were suddenly collapse into a much shorter lag?  No precedent exists in the history of man where life as we know it was endangered the way it could be from an irreversible change to a hostile environment, so there’s no way to know how markets would handle the news.

Assuming nothing dire occurs in 2015, the last consideration is whether the dollar’s current level looks over-bought historically after the run-up in 2014 or if it is already causing big problems to U.S. competitiveness.  Last week’s essay demonstrated that has not become the case as yet.  A rising dollar continuing next year seems to be the likely path of least resistance.  Last warning: foreign exchange can be very fickle.  It’s never prudent to lock a strategy in the vault, go away, and expected profits to pile up.  Since currencies react to virtually everything, exposures need to be monitored and reexamined constantly.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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