We have commented a number of times (for example) on the market’s current obsession with trying to infer secret meaning from policy makers’ every word. The word of the moment is ‘patience’. As the US economic recovery has been forging ahead of most of the developed world over the past couple of years, the extent and timing of an interest rate rise in the US has been a key area of fevered speculation among investors. As result, the Federal Reserve find themselves in a delicate situation as they attempt to balance attempts at open communication with the market with investors’ readiness to pounce on any indications – either intentional or seeming slip of the tongue – that could provide a clue to uncovering the big enigma.
And so we arrived at last week’s Fed meeting with the word ‘patience’ being highly scrutinised across the financial world (such as here, here and here to highlight just a tiny sample of examples). It is easy to be flippant about something like this but while dropping the word patience does not tell us anywhere near as much as most commentators would like it to about the US’ macroeconomic outlook, such things can been quite meaningful in terms of short-term market movements. Back in summer 2013 the world ‘tapering’ sparked a dramatic sell-off on treasury markets. This time it looks like investors have decided to focus on currency markets, partly due to the ECB’s recent monetary policy moves, along with the 21 other countries that have lowered their interest rates in the past couple of months.
Recent currency movements have been pretty extreme. In the past six months the US dollar has been strong against not just emerging market currencies, but also those of the other major blocs. Since the beginning of September 2014, the Brazilian Real has fallen by nearly 30% against the US dollar, the Euro has fallen by nearly 17% and the Japanese Yen has fallen by 12%. Movements in the past month have been particularly dramatic – as illustrated by the Euro recently moving from 1.14 to 1.06 against the dollar in a matter of days (20 February to 12 March 2015).
So, how much farther can the USD strengthen? Forecasting spot movements in currencies with any degree of accuracy is an impossible task. And compared to trades where a positive carry is involved (i.e. if the destination currency is offering a positive yield) prognostications on the future path of the dollar are fraught with a greater than usual degree of uncertainty. But when we consider the important fundamental divergence which has been driving the recent behaviour of currency markets, it seems eminently plausible for the US dollar to strengthen materially further, especially versus the euro and the yen.
The past few years of extraordinary measures have led us to a highly unusual point of divergence in global monetary policy. It’s not just about timing, with the Federal Reserve leading by a few months, as has been the case in the past – it’s about the very direction and imperative of policy.
History tells us that when countries embark upon asymmetric policies, the consequences can be significant and surprising in their magnitude. With the US being pretty much the only country tightening its policy while the majority of the world is easing, this is an environment which invites large fx moves as investors re-positon their ‘value anchors’.
We have already seen a substantial dollar move. But in contrast to the notion that today’s higher price merely ‘brings forward’ future returns which, rationally, prevails in other asset markets, such big moves may beget yet more strength as investors seek to re-establish a psychological anchor for the currency’s value with the previous reference points having been questioned and discarded.
At the turn of this year, dollar-euro parity still seemed very far away, with a trading-range floor of around 1.20 seemingly being justified by the standard relationship between short term interest rates (see the figure 1). But by the middle of March a decade low of 1.06 was reached – and suddenly we need to cast our data and our minds back a little further in time to reassess what is plausible (see figure 2). Given the sharp differences in policy stance that seem highly likely to remain, a yet stronger dollar/weaker euro should probably be our expectation from here.
With this in mind it seems appropriate to borrow a phrase from Ronald Reagan in the early 1980s: ‘you ain’t seen nothing yet!’