Not going to (the dollar) plan

Once again, the consensus on FX is struggling to be proven correct and there are strong echoes of six months ago. Back in early July, the Fed tapering story was gathering pace. Partly in response, the Bank of England (in one of the new governor’s first acts) actively warned against rising rate expectations spilling over into the UK money markets. A month later, the Bank announced explicit and condition forward guidance. Also in July, the ECB announced that rates would remain low “for an extended period of time”.

As it happened, sterling was the strongest performer in the second half of 2013 (up nearly 9% vs. the dollar) and the euro was not far behind (up 5.2%). This was despite the fact that both kept their pledges (the ECB even cutting rates) and the Fed did eventually taper. The underlying hope is that diverging macro and hence monetary policy trends will return to be a key driver of currencies, more like the pre-crisis days of old. It didn’t happen, which is why many macro FX managers had such a difficult time in the second half of last year, having made good on the yen and Aussie in the first half.
Are we heading for a repeat performance this year? After all, the calls for dollar strength remain pretty solid, but it’s hardly one-way traffic. Furthermore, the primary candidates for shorting vs. the dollar (the yen and Aussie once again) were both appreciating early in January (we’ve seen some pull-back overnight).

Dollar bulls should not lose faith. After all, we are barely two weeks into the New Year, but as my oldest mentor in FX often used to say, nothing moves in a straight line. Broadly speaking, the price action so far fits with my view that this is going to be a year of conditional dollar strength. By that I mean that the gains in the dollar are going to be modest in comparison to past dollar bull trends of around 4% on the DXY index. Compare that to the average 15% gains seen in the 1980, before international action to curb dollar strength in the 1985 Plaza Accord. In the mid-to-late 90s the annual average gain was near to 7%. So within a 4% annual gain, there are going to be plenty of pull-backs and corrections.

For this quarter at least, expect the dollar to appreciate, but not against everything. The Aussie still remains our more favoured currency to weaken. The single currency, even with Year End pressures having passed, remains one of my favoured areas of resilience. This was in evidence in the wake of the press conference last week. Even though the ECB strengthened their forward guidance and pledged to do more if necessary, the currency soon regained the losses.
For me, it’s clear we have to look beyond simple monetary policy actions and intentions. Since early November the change in 3-month money market rates in the US has been zero, despite the Fed tapering bond purchases. In the Eurozone, the same rate is nearly 10bp higher, despite the ECB cutting rates and strengthening forward guidance. The mistake is to ignore liquidity and the transmission mechanism from what the central bank does to what happens with market rates and eventually the real economy.

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