This is the first of several blogs for my half year review and look ahead. This is more looking back, but nevertheless this is always an important part of this. Looking back at what you got right (and if it was for the correct reasons) and also what you go not so right.
The subtitle to our 2014 dollar outlook ‘subtly stronger’. The first half of the year stretched the definition of subtle to the limit (dollar index up just 0.3% to 23rd June) and the dollar did not wholly perform in the way we envisaged, but we were correct in saying we were not heading for a “secular dollar bull market as the Fed starts tapering”.
The disappointing performance of the US economy was the key driver of the dollar early on, but underlying this was the fact that the relationship between quantitative easing dynamics (in this case the tapering of bond purchases) and the dollar was a lot weaker than was the case in the early days of the financial crisis. As such, we found the “tapering = firmer dollar” mantra as flawed in its approach.
On the majors, our biggest miss was the Aussie and yen (0.85 and 107 for end Q2) . Even though we recognised that the Aussie was far less correlated with China, the domestic economy and the shift in stance from the RBA were the key drivers to the strength, together with the generalised search for yield as volatility was crushed to multi-year lows across most asset classes. As for the yen, we were added to the pile of other forecasters who have tried and failed to fully rationalise the Japanese currency.
We were closest on the euro, although not quite achieving our end Q1 target of 1.41 (end Q2 1.38). Back in December, the market (Bloomberg survey of forecasts) was looking for EURUSD at 1.30 by mid-year, reflecting the view that further easing and deflation were set to weaken the single currency. The sterling strength we were envisaging for Q1 did happen and more rapidly than we anticipated. The surprise was the shift in interest expectations into the end of Q2, with Carney indicating a potential rate rise by the end of the year, a view which we took on board before his speech and continue to believe will come to fruition. The market was looking for cable at 1.60 by the end of Q2, so we were on-side (seeing 1.63) vs. the market, but some way off the reality (only 2 of 70 forecasters saw above 1.66).
The other development, that did have implications for FX, was the collapse in volatility and also bond yields during the first half of 2014, especially in the eurozone periphery. The fall in volatility was caused in part by central bank policies, including forward guidance, together with the steady and assured pace of Fed tapering.