As 2013 draws to a close and the volatility in the financial markets decline, we want to take this opportunity to venture away from our daily summaries to discuss our outlook for the currency market in the coming year. We start with the Dollar and move to the Euro, Japanese Yen and other currencies. By New Years Eve, we plan to publish our last outlook focusing on our Favorite FX Trades for 2014.
While it may seem like the U.S. dollar has had a good year, on a trade-weighted basis, it is up less than 1%. The dollar has performed extremely well against the Japanese Yen and Australian dollar but with just over a week left before the end of the year, it is trading lower than where it started against the euro, Swiss Franc and British pound. Yet it has still been considered a good year for the dollar because the losses against European currencies are less than 4% whereas the gains against Asian currencies are closer to 15%. This has also been a good year for U.S. stocks, which hit record highs and in the Treasury market, 10 year bond yields rosed more than 100 basis points from 1.75% to 2.9%. The simultaneous rise in stocks and bond yields is a reflection of the market’s positive outlook on the U.S. economy. The mixed performance of the dollar tells us that relative growth and monetary policy divergence played a bigger role in 2013 currency trade than the market’s appetite for dollars.
America’s Turn to Shine
Many investors believe that 2014 will be the year to buy dollars. In December, the Federal Reserve decided that it was time to begin unwinding its largest economic stimulus program ever and while the amount of reduction in monthly bond buying was small, it marked a major turning point in U.S. monetary policy. Bernanke also signaled plans to reduce bond purchases on a consistent basis in the coming year, eventually bringing Quantitative Easing to a halt. We’ll discuss this in further detail later but first, the unwinding comes at time when growth will shift from the East to the West – 2014 is the year for America to shine. For the past decade, the growth story has been in Asia and more specifically China but in the coming year, faster growth in the U.S. and slower growth in China will make U.S. assets more attractive to global investors. At 7%, China’s expected 2014 growth rate will exceed the U.S.’ 3% rate but U.S. growth is accelerating while Chinese growth is slowing. Less fiscal drag and a more solid cyclical recovery next year will give banks the confidence to lend and households the willingness to borrow. Earlier this month, U.S. Senators passed a budget deal that would avoid another government shutdown in mid January. The debt ceiling debate is still an uncertainty but with the midterm elections looming few politicians in Washington have the appetite for another fiscal fight. So as the Federal Reserve reduces its bond purchases, interest rates in the U.S. will rise, attracting foreign investment out of Asian economies that are vulnerable to weaker Chinese growth. More foreign investment will be positive for the dollar.
The Big QE Unwind Plus Major Changes in the Fed
Stronger growth next year also makes it easier for the Federal Reserve to stick to its plans to reduce asset purchases consistently and while higher U.S. rates is a certainty, the unwind of QE may not be as positive for the greenback as many investors hope. First and foremost, many market participants were already positioned for the reduction in asset purchases and while not everyone was positioned for an end to QE, the new Fed Chairman could alter the course in the coming year. While Janet Yellen supported the decision to taper, the forecast for a $10 billion reduction at every successive meeting was from Bernanke who won’t have a say on the pace that Quantitative Easing is unwound. Janet Yellen is one of the most dovish members of the FOMC and in her confirmation hearing she made her focus on growth versus inflation abundantly clear. Also the central bank emphasize that short-term interest rates will remain near zero “well past the time” that the unemployment rate hits 6.5%. A careful exit will be Yellen’s number one priority and if growth hits a snag, she won’t hesitate to slow the reduction or change the thresholds to manage expectations.
There are 2 ways that Yellen could strengthen the forward guidance that could cap the dollar’s gains. She could drop the unemployment rate target from 6.5% to 6% or add a qualifying statement that says rates will not be increased until inflation rises above 2%. This is entirely impossible especially if weaker growth in China spills over to the U.S. or job growth suddenly slows. Bernanke and Yellen also have different views on inflation, he believes the drop in inflation is transitory while Yellen believes that inflation will not rise rapidly. Aside from Yellen, the FOMC has 4 new members next year. Stanley Fischer has been nominated as the vice chair of the Fed (Yellen’s current job) and he is widely viewed as one of the more hawkish members of the FOMC. Plosser and Fisher who also share his hawkish views will be rotating in as voters in 2014. He will be joined by Pianalto, a moderate dove and Kocherlakota, an uber dove. This makes the general makeup of the Fed in 2014 less dovish than 2013.
Is 2014 the Year to Buy Dollars?
At the end of the day, the big question is whether 2014 is the year to buy dollars. With the end of QE in sight and U.S. rates expected to head higher, we expect the dollar to extend higher but investors need to be selective about what currencies to sell the dollar against.. The magnitude and sustainability of the gains however will depend on the growth and direction of monetary policy in the major economies. The dollar should performance best against currencies of countries whose central banks are looking to loosen monetary policy such as the EUR, JPY and AUD. If Eurozone data continues to weaken and inflation in the region falls at a faster rate, making the ECB more serious about easing, EUR/USD could drop as far as 1.33. However if the ECB remains dovish but fails to move on rates, losses in the EUR/USD could be limited to 1.35. The chance of additional easing by the Bank of Japan next year is high and this means at bare minimum, USD/JPY is headed above 105. The extreme level of long USD/JPY positions in the market could make for choppy trading but eventually widening interest rate differentials between the U.S. and Japan should take the pair to 108/109. Investors need to be very selective next year because we are not looking for significant gains in the dollar versus the GBP and NZD because rates in the U.K. and New Zealand could move up at a faster pace.
Stay tuned for our next EUR/USD outlook.