Currency Landscape as 2015 Draws Nearer to Completion

December 21, 2015

The past twelve months have seen the U.S. currency strengthen broadly but most sharply against emerging market and commodity-sensitive currencies.  Net dollar changes since end-2014 or -0.1% against the Swiss franc, +1.3% versus the Japanese yen and +4.5% relative to the British pound were generally modest, while advances of 11.2% vis-a-vis the euro, 14.3% against the Australian dollar, 16.1% versus the New Zealand dollar and 20.0% against the Canadian dollar were significant.  The Chilean peso, Mexican peso, Indonesian rupiah, Russian ruble, Norwegian krone, Swedish krona and gold dropped over 10%.  The Colombian peso, Turkish lira and South African rand lost over 20% of their dollar value, and the Brazilian real plunged more than 30%.  West Texas Intermediate oil and the Argentine peso imploded over 35%.  The steepest downtrend of the Chinese yuan in many years started a few weeks ago. 

Other financial markets moved in greater lockstep.  In the case of ten-year sovereign debt yields, there has been little net change, with Treasury and German bund yields up a mere two basis points since end-2014, the 10-year JGB off four basis points, and the 10-year British gilt up 7 bps on balance.  Equity market gains since the end of last year of 9.2% in Germany and 8.3% in Japan contrast with drops of 7.1% in the British Ftse and 3.2% in the DJIA. 

Fundamental economic comparisons against a year earlier do not isolate the United States in a bright light that ordinarily would suggest the kind of dollar appreciation that we’ve seen.  In the year between the third quarters of 2014 and 3Q15, real GDP expanded 2.3% in Britain, 2.2% in the United States, 1.6% in Japan and 1.2% in the eurozone.  The latest twelve-month changes in consumer prices — up 0.5%in the United States, 0.3% in Japan and Britain, and 0.1% in Euroland — are essentially indistinguishable.  Current account-to-GDP ratios in the U.K. and U.S. (deficits of 4.5% and 2.7%) compare unfavorably with the surpluses of the eurozone (3.0%) and Japan (2.6%).

The strength of the dollar doesn’t rest on slumping oil prices as it might have done once upon a time.  The United States had transformed into a monster energy producer at higher prices via the development of shale production.  Being invoiced in dollars, cheapening oil imports translates into diminishing source of dollar demand.  Likewise, China’s economic setbacks do not necessarily favor the United States.  The clearest victims are other emerging markets, but from there the effects will ripple out into advanced economies, too.

A scenario of dollar strength in 2015 spilling over into 2016 rests most heavily on the contrast of Fed tightening with full-bore quantitative stimulus by the European Central Bank, Bank of Japan and other monetary authorities.  The dollar in fact was bid higher in 2015 largely on the expectation that the Fed would start normalizing the federal funds rate by yearend, which has now proven to be a correct assumption.  Further follow-through by the FOMC and the dollar in 2016 hinge on the perceived appropriateness of a campaign of gradual increases in the federal funds rate.  The qualifying and operative “word” in this process is “gradual,” an acknowledgement that the new normal bears little resemblance to the historic normal, and that means that, however carefully engineered by Fed officials, the response of financial markets, the U.S. economy, and the global economy is fraught with uncertainty. 

Despite the support of a zero interest rate policy, U.S. economic growth of 2.2% per annum over the 25 quarters of the current upswing has been relatively modest.  Over equivalent intervals at the start of the previous three recessions, the positive growth of real GDP had averaged 2.6% a year through 1Q08, 3.6% through 4Q97 and 4.8% through 1Q89.  Wage and price inflation were higher at the onset of those tightening campaigns, too, and global demand momentum was more reliable.

The dollar’s ability to capitalize on Fed monetary restraint and the contrast of the Fed’s stance with monetary policies in other countries could be hindered by several other factors.  Foremost will be the U.S. presidential and congressional election next November.  America is undergoing a midlife crisis and the diverse sense of national identity is exemplified in immigration policy.  The soul of the Republican Party wants to deport muslims and the families of illegal Hispanics, while many Democrats would rather just deport Republicans. These irreconcilable differences are highly entertaining in the media but also could become unsettling to holders of U.S. assets, sufficiently so perhaps to undermine any dollar appeal on purely economic grounds.

In the course of the election campaign, criticism of the strengthening dollar and the possible harm such might pose to the competitiveness of U.S. manufacturers could become a highly public point of contention and a deterrent to how high the dollar might climb, pending the outcome of the November vote.  Given the vastly different manifestos of the two parties, any closeness of the two sides in the parade of opinion polls also should limit the magnitude of cumulative swings in the key currency relationships.

The U.S. current account deficit is presently manageable but faces an upside bias.  In a low growth/low inflation global environment, deficits are problematic for the currencies of countries with debt denominated in appreciating currencies.  But historically when movement in the U.S. current account becomes very one-directional, dollar sentiment has suffered.

Another good year for the dollar would carry it though parity against the euro, past the JPY 130, and toward 1.40 per pound.  If the U.S. currency were to hold most of its present bilateral values, it would be a decent year for the dollar and an even better year for the U.S. economy than likely under the first scenario.  Stability in the dollar after a sharp upward run is not particularly likely.  When currencies in  motion stop grinding along the established direction, a reversal often follows rather than a flattening pattern.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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