The State of the Bull

(here is a draft of my monthly column for a Chinese paper)

The US dollar has had a rough few months.  It has fallen against most major and emerging market currencies this year.  A critical issue for global investors and policymakers is whether the dollar’s uptrend is over, or is this just a respite.  Much is at stake with the answer.

The variability of exchange rates could account for a third of the total return of a basket of international equities and twice as much for a basket of international bonds.  Since many commodities are priced in US dollars, the greenback’s direction tends to influence their dollar price.  Many emerging market countries and companies have borrowed dollars, and an appreciating dollar, exposes a potentially painful currency mismatch. 

In order to begin answering the question, it is helpful to return to basics.  What was the driver of the dollar’s rally?  There are many different narratives, but the most compelling one focused on the divergence between the US and nearly the rest of the world.  The US responded early and aggressively to the Great Financial Crisis, and this produced superior economic outcomes. 

For example, the US began an asset program to expand monetary support after the Fed’s policy rate was near zero in 2009.  Europe and Japan began several years later.  The US began tapering its purchases before the ECB launched its asset purchase program.  The Federal Reserve raised the Fed funds target range while the ECB and BOJ were still in the process of expanding their unorthodox policies, which include negative policy rates. 

There are other divergences, some which follow from the divergence in policy; others are independent.  Large US banks were forced to take government capital, whether they needed it or not.   This removed the stigma and allowed the banks to be recapitalized quickly.  Europe, which is more bank-centric than the US (which is more market-centric) has still not addressed its banking problems.  The problems can be found in core countries like Austria and Germany, and not just in the periphery. 

Japan and Europe are also still battling deflationary forces.  In the US, excluding food and energy, inflation has been steadily rising, despite the previous dollar strength.  Core CPI is above 2.0%.  The Fed’s preferred inflation measure, the core deflator for personal consumption expenditures is up 1.7% over the past year, just below its 2% target. 

Looking forward, it is possible that the Bank of Japan and the European Central Bank have not reached peak accommodation yet.  The ECB took action on multiple fronts in March, and all of the new initiatives have not been implemented.  The corporate bond buying program and the new loan program, at possibly negative interest rates will be launched toward the end of the quarter. 

 

The Bank of Japan is pursuing arguably the most aggressive monetary policy in history.  It may not have reached its limit yet.  Without the ability to intervene in the foreign exchange market, the BOJ may be the only one who can act. 

The road to intervention was effectively blocked by lack of support among the G20.  The Japanese yen has risen almost 10% this year.  The Canadian dollar has risen by nearly 9%.  Canadian officials are not itching to intervene.  As fraction of GDP, Canada exports nearly twice as much as Japan. 

If the BOJ does not ease at the end of April, either adopting more negative interest rates or increasing the assets it is buying, including ETFs, there will likely be disappointment that could lead to spike in the yen.  While weak yen proved no panacea for Japan, a strong yen at this juncture, can act as a new headwind on prices, corporate earnings, the equity market, and the current account. 

When learning to drive, we are often instructed to aim high in our steering, which means look up the road rather than just the few meters in front of you.  So too when considering the outlook for the dollar. 

There may be near-term volatility and counter-trend moves, but the divergences between the US and Japan and the US and Europe are still growing.   We have not reached peaked divergence.  Interest rate differentials are one way to think about the cost of being short the dollar. 

When there is a countertrend, the momentum will offset the carry.  However, when the euro or the yen stall out, which is beginning seem like the case, it quickly becomes painful to be short the greenback.  And even if people like myself are having difficulty timing the pace of the Fed’s hikes, we can still be confident of the direction of policy.  The ECB will be expanding its balance sheet for almost another year, at the bare minimum, and the BOJ has no terminal date to its unorthodox policy.

The dollar’s driver, divergence of monetary policy remains intact, and still has more than a year to run.   It does not mean that dollar will appreciate every day or every month, of even every quarter.  It does mean that the incentive structure created by interest rate differentials and shape of curves provide powerful incentives for investors to be long dollars.  

Disclaimer