Forex trends in 2014: U.S. dollar outperforms competition

Forecast for U.S. dollar, euro, pound and gold

Conditions look set for the U.S. dollar (NYBOT:DXH14) to rally next year with the U.S. economy showing some real vigor and the U.S. Federal Reserve starting the process of tapering its quantitative easing program beginning in January. It should also be a good year for the global economy.

The markets will be looking toward economic growth gradually replacing quantitative easing and diverging real interest rate levels as the key drivers of forex markets next year. Although this looks like a return to more normal conditions, there are a number of troubling issues to consider, which will be looked at later in this note.

After a few hiccups, the Fed masterfully communicated its taper so as to be viewed as good news by the markets rather than a dreaded withdrawal of liquidity. It can happen because the news from the U.S. economy has been so good recently. Shifting from QE to forward guidance on interest rates as a key monetary tool cheered the stock market, but has the potential to limit the USD's gains in the short-term.

But if the U.S. recovery does prove sustainable, then there is good reason to expect that the Fed could even start tightening monetary policy in late-2014 early 2015 – putting it way ahead of the Eurozone and Japan in terms of the interest rate cycle. That should be bullish for the USD.

EUR looks set for stability

The euro (CME:E6H14) defied expectations in 2013 by being one of the best performing major currencies. The toning down of the Eurozone crisis and increasing economic confidence all played a supportive role. Even the peripheral Eurozone countries are showing signs of improvement, which is crucial to the long-term survival of the euro.

However, the Eurozone is still a laggard in terms of generating an economic recovery.  So while the Fed is reversing its easy money policies, the European Central Bank will still be in aggressive monetary stimulus mode. But a strong U.S. economy will be like manna from heaven for the Eurozone, which should start noticeably recovering by H2.

A strong U.S. recovery does therefore limit downside risks for EUR/USD (FOREX:EURUSD). But the upside is also potentially limited given 2013's strong gains and the fact that it lags in the economic and interest rate cycle. EUR/USD will probably trade in a range of around 1.3200-1.4000 next year.

JPY likely to run up more losses

Of all the major central banks, the Japanese one looks set to be the most aggressive in 2014 in terms of easy money policies. On the face of it, Abenomics seems to be working. Inflation appears to be replacing deflation, business confidence is up and the economy has shown some growth.

However, credit growth, which usually happens in tandem with a steadily expanding economy, is not really happening and because of its rapidly ageing population, Japan's labor force is shrinking. If a U.S. recovery proves sustained and lifts other economies Japan could benefit from export-driven growth.

A prevailing risk-friendly environment will see Japanese investors pursuing growth and yield opportunities abroad. Forex traders meanwhile will be inclined to make more use of JPY for carry trades. USD/JPY (FOREX:USDJPY) is likely to be in a range of 103.00-110.00 next year.

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