2014 – The year of the dollar, again…
A good friend of mine, an economic journalist, was teasing me a week ago: “You economists called for a ’year of the dollar’ in 2010, 2011, 2012, 2013 and now you’re doing so again in 2014. Every year you’ve been proven wrong but you persist.” In embarrassed response, I offered up my usual three lines of defense.
First, in 2013 I didn’t call for a year of the dollar as many of my colleagues had – at least not until May. Second, I can understand why they did so. Third, forecasting currencies is like driving a car blindfolded with a passenger giving you directions by looking through the rear window.
“And yes, you’re right,” I added, “I am now, in 2014, calling for a ’year of the dollar.’ It should appreciate to almost 1.25 against the euro and close to parity against the Swiss franc within the next 12 months.”
Humbly acknowledging that currency forecasts are more often wrong than right, I nonetheless think that there are good reasons to make such bold predictions. But if we have any chance of getting this one right, we need to go back in time and ask ourselves what the driving forces behind currency movements were over the last few years.
In the aftermath of the 2007–08 financial crisis and the 2008-09 Great Recession, the structural problems of the euro, which was (and remains) the common currency of a non-optimal currency area, led to the euro crisis. While not yet solved for good, the crisis is at least currently on the backburner for market participants, as illustrated by the rally of European peripheral countries’ government bonds in recent months.
Those same bonds, during the height of the euro crisis, came under such severe speculative attack that several of the countries required bailout packages and one, Greece, was even forced to default partially on its government debt.
Talks about such-and-such country leaving the common currency made frequent headlines between 2010 and 2013. Nonetheless, the crisis-ridden euro not only held the line but even managed to appreciate against the US dollar. How can we explain this paradox?
Obviously, one reason is that the European Central Bank (ECB), which was focused exclusively on an elusive inflationary threat, kept its monetary policy on hold despite the fact that the Eurozone was experiencing its second recession in less than four years during 2012–2013.
In my view, however, the strength of the euro against the dollar couldn’t have been maintained by the ECB alone. The other side of the exchange rate also had to play a role. In fact, the main reason for euro strength was the dollar weakness engineered by the successive quantitative easing programs of the US Federal Reserve. “Choosing between the euro and the dollar is ultimately like choosing between plague and cholera” became one of my favorite currency bon mots of the past five years.
The narrative of the currency markets in recent times has been in my view a relativity tale between the major central banks. The “softer” a central bank’s stance relative to its peers’, the more its currency weakens against the others’.
This narrative hasn’t changed, but what is changing is market perception of the central banks’ relative softness. While the Fed has started to taper and, according to both our view and market consensus, will continue to do so, the ECB is struggling with deflationary pressures. If signs of deflation continue to materialize, further expansive monetary policy actions will be needed in the Eurozone.
This line of thinking, among others, has led us to more strongly overweight the US dollar in our currency strategy and underweight the euro.