Since Federal Reserve Board Chairman Ben Bernanke first hinted back in May that the Fed at some point would reduce the amount of monthly bond purchases (QE3), talk of a taper and its effect has dominated all market sectors. Currencies are no different. But the one constant in financial markets over recent years is a gnawing uncertainty. The economy has experienced slow, tepid growth and, just as the recovery looks to gain steam, there is a downturn. All Fed action is data-dependent and the data is screaming, “ugh!” Things are better but we aren’t out of the woods yet.
A consensus was building that the Fed would begin tapering at this September’s FOMC meeting, which would be U.S. dollar positive, but weaker jobs growth in the July employment report may have pushed it back to the 50/50 range.
“The entire tapering debate is the biggest catalyst for the dollar at the moment,” says Andrew Wilkinson, chief economic strategist for Miller Tabak & Co. LLC.
George Dowd, head of Chicago foreign exchange for Newedge, sees tapering occurring earlier than consensus based on better employment numbers (we spoke before the July report came out; one more employment report will come out before the Fed meets next). Dowd expects a taper in September and thinks it may be more substantial than expectations.
“You have to look at where they are going to go with the purchases as well,” he says. “Currently they are purchasing $45 billion in Treasuries and $40 billion in [mortgage-backed securities]. The market consensus for the September meeting is they go 35 and 30; I think they can go 30 and 30.”
While the taper is generally bullish the dollar, Wilkinson believes — like the initial reaction to taper talk — the dollar rally may have gotten ahead of itself.
“What changed in [July] is that the market has dealt with the distinction between tapering and raising interest rates. It shouldn’t be confusing. Price action tends to mislead investors and that is exactly what happened. Rising bond yields immediately impacted the stock market and the logical conclusion was that the Fed is tightening, and that wasn’t the case,” Wilkinson says. “What has transpired over the early part of the summer is that the dollar is not set to benefit any time soon from rising yield differentials on account of official interest rate rises, so as the market discounts that, investors’ appetite for dollars become less.”
Sharpe + Signa Managing Director Garen Ovsepyan agrees. “Fed tapering is dollar-positive in terms of market sentiment; however, as far as money markets are concerned, tapering is not necessarily a hike in rates,” he says
Ovsepyan points out that the dollar consistently has failed to take out significant technical resistance at 83.50. “If the Dollar Index trades convincingly above 83.50 at least on a weekly basis, we adjust our view from bearish to neutral or possibly mildly bullish.”
Dowd, however, sees the dollar’s slide in July as an opportunity. “It has had a nice little retracement down from where it had been; you cleaned out a lot of weak longs,” he says. “The fundamental focus going into year end is going to be dollar-bullish; I am expecting new highs in the dollar index going into year end. You will see the dollar trading up around 85.50-86.00.”
Jason Rotman, president of Lido Isle Advisors, says the data needs to justify dollar confidence. “A lot of people are looking for the U.S. dollar to start to go up again and break this year’s high of about 85, but it is not doing that, it is not coming close,” Rotman says. “For the U.S. dollar to continue its 2013 bull trend, it will need several months of phenomenal nonfarm payroll growth and even start to see the core [Consumer Price Index] numbers [come in] consistently above expectations because the Fed does not want to crash this market with a premature statement of stimulus reduction.”
FXCM Chief Currency Strategist John Kicklighter sums up the divergence of opinion on the dollar: “For the remainder of the year, one of the takeaways is that it is going to be extremely volatile.”
He adds, “It is a game of competitive stimulus. It is going to have an impact on the dollar. If we see the taper occur in September, it is the thing that could cause the dollar to continue higher.”
One reason why Kicklighter is expecting greater volatility is the divergence between the S&Ps and the carry trade. “You have a strong correlation between the S&P 500 and the carry trade index (see “Volatility watch,” below). Just over the past three or four months you have seen a very substantial divergence in their performance,” Kicklighter says. “This is one of those early warning signs that you get when the markets [don’t assume] that there is going to be very low volatility. I don’t think there has been a carry trade because of these concerns. The carry trade has a lot more room to unwind, especially if things get dicey.”
Another divergence Kicklighter points out is the dollar is a safe haven. While that always will be the case, he points out that its correlation with the S&P has built in 2013 despite a strong equity rally with low volatility (see “Safe haven or risk asset?” below).
He says the dollar will get to 90 by year end but not go beyond it. “To make the transition, you have to have extreme risk aversion and the dollar is already essentially at a three-year high so a lot of the taper concern has been priced in. … but I don’t think you will get beyond 90 until you have the conversation that you are moving beyond stimulus.”
And therein lies the rub because as the U.S. central bank is debating when to take money out, others are looking to add more stimulus.
“You are talking about the Fed at the crest of its stimulus program while the Bank of Japan just recently hit the accelerator, so they are at different phases of their programs,” Kicklighter says.
And it is not just the yen. New Bank of England Governor Mark Carney is making noise that the BOE will add stimulus soon, as is likely with the European Central Bank (ECB) and the Reserve Bank of Australia.
“The euro is in a curious place because on the one hand monetary policy looks set to ease in the Eurozone even as the economy improves, and as the economy continues its improvement more people appear to be buying the euro, which in effect is creating tighter monetary conditions,” Wilkinson says. “That in itself argues for further easing from the ECB.”
Dowd says, “I don’t think the ECB is opposed to having the euro weaker. So if the dollar gets strong, the first step on the downside [for the euro] after you get past the 1.2740 [2013 low] is 1.25. Germany is the big question. It is really how much Germany wants to continue to carry some of these peripheral countries.”
But the euro has shown resilience in 2013 and may be in in a good spot where growth is beginning to pick up, but not so much as to prevent further stimulus.
“The euro is really the weakest link, though one of those things that has helped it is the fact that it is always in trouble: Greece, Ireland and rest of the [peripherals],” Kicklighter says. The euro is going to be interesting because it really depends on how robust risk trends are going to get. You probably will be down to 1.25 by end of year. The [British] pound will drop back to 1.48.”
“The euro has been extremely strong,” Rotman says. “It has been in a range from 1.27-1.34 throughout the summer. Now we are getting pretty positive economic confidence data coming out of the Eurozone and Germany. Even though the European officials have said that the job growth is horrendous, you really could not tell that by looking at the euro. It is at 1.33 and approaching the range high of 1.34. Any time it has gotten to the bottom part of the range we have found significant buying. I could see 1.36.”
Wilkinson sees this, but says, “My outlook for the euro is to fight the trend. The trend is very clearly upward and that is tripping a lot of people up. Most people are not looking for monetary tightening, with many looking for easing. I don’t think improving growth prospects is a sufficient factor to drive the currency higher at this point.”
Dowd also is skeptical of euro strength. “The euro has some structural issues; we can get down to 1.2450-1.2500 before year end.”
Ovsepyan splits the difference, expecting the euro to settle near 1.3000 by year end.
So there you have it — analysts are split between the euro making either a yearly low or yearly high as 2013 comes to a close.
In our April currency outlook, we mentioned there was some fear of a currency war based on a statement from the Group of 20 at its Moscow Summit expressing concern over the level of central bank machinations and a chance some countries might be labeled currency manipulators. That seems to have calmed down and most view the various central banks as simply doing what they can on the monetary side to support their economies.
“Japan has been the [closest] example of manipulation that you are going to get,” Kicklighter says. “They don’t label them a currency manipulator because if you label Japan a manipulator, then you would have to label China a currency manipulator and then you would have to say the U.S. is a currency manipulator because we moved our stimulus program to exceptional levels.”
He adds, “The appropriate term is ‘competitive stimulus gain.’ You have to measure what their objectives are, they have to prove that you are trying to manipulate the exchange rate simply for the exchange rate sake rather than promoting domestic growth.”
Rotman says active central banks are a part of life today. “That issue is so widespread and commonplace in today’s central-bank-dominated currency marketplace. Central banks overtly affect the currency markets on a daily basis. That is the reason the Aussie dollar went below the 90 level [at the end of July].”
Dowd sees the move down in July in the yen as more corrective. “[The yen] is going to move up to 105. By year end the yen will be around 105-110.”
Dowd has the consensus opinion but the yen has improved against the dollar despite the interventions of “Abenomics” to weaken the currency based on Japanese Prime Minister Shinzo Abe’s policies.
“We are going to have a pullback in the yen for the next month and a half but eventually end the year at 105,” Kicklighter says.
“The pace of yen weakening has stalled with the yen trading below 100,” Wilkinson adds. “I believe it is a correction; ultimately the yen will trade between 104 and 110, whether that is before the end of the year I am not sure.”
Rotman pegs 105 in the yen by year end. Ovsepyan is the outlier, pegging 98 in the yen.
A permanent concern in all markets and market sectors is China, and slow growth in China has been blamed for the extreme weakness in the Aussie dollar.
“I have been of the opinion that the Chinese economy is slowing because of what happened in the Eurozone. Yes, there is some domestic slowdown in China but it appears the Chinese authorities will step in to support growth even if it is slipping to a historically low level,” Wilkinson says.
Dowd says, “Australia is going to be dependent on how things go in China but when you look at that chart it looks a little oversold right here. If we can trade above 95, the market gets back on a flat position.”
Wilkinson points out that China has emerged and may see lower GDP numbers as a result. “As the Eurozone news becomes less bad, you will definitely see a pick-up in Chinese activity. Whether that is sufficiently strong to drive a rally in the Aussie dollar is [debatable].”
Also debatable is whether weakness in the Aussie dollar can be blamed on China or if the reason is closer to home.
Rotman says central bank statements, not Chinese weakness, is the reason for the fall. “It is because Australian central bank chief Glenn Stevens blatantly said ‘we still think our currency is too high.’ You can’t get much more obvious than that. As soon as he said that the Aussie went from 91 to 89.”
Whether you blame it on China or Stevens, it has caused a split in the once dependable correlation in the commodity currencies (see “No longer best buddies,” below).
Opinions are varied, and of course data-dependent. The one wildcard mentioned by most analysts is a significant change in the expectations of a tapering, but more importantly the fundamental reasons for such a change. Dowd sums it up, “The real wildcard would be if the [United States] turns down again. If we saw a real deterioration in the employment numbers or the housing market in the [United States], that would be a game changer.”
The U.S. dollar appears strong because the U.S. economy is preparing to begin weaning itself from extraordinary accommodation while the rest of the world is at the trough. If the numbers don’t justify it, things could change.