Divergence and deflation dominated forex in 2014

December 23, 2014 08:07 AM

For the forex markets 2014 can be largely summed up in just two words: Divergence and Deflation. It was also the year of the dollar, which enjoyed a spectacular rally.

The U.S. Dollar Index was around 80 at the end of December 2014 and by the end of December 2015 it was 89.60 with it really finding its momentum from June onwards.

The dollar rally is one side of the divergence story. In a nutshell the US economy grew at a steady pace and unemployment levels fell. However, the rally got off to a wobbly start this year partly because of Janet Yellen taking over at the U.S. Federal Reserve in February.

As with all new Fed bosses, the first few months represent a period of uncertainty as the markets get a handle on the new regime. However, what really drove the USD rally in 2014 was the taper story–that is the run up to the end of the Fed's quantitative easing programme in October.

That unleashed the so called taper tantrums with risk assets and currencies frequently taking a battering at the prospect of the U.S. monetary policy cycle turning.

Meanwhile, the UK economy had a very good year as did the property market and employment, which rose rapidly due to strong jobs creation. 

But there were also some negatives for GBP. The current account deficit remained large, there were ongoing concerns about the poor state of the Eurozone just across the channel and there was the Scottish referendum over whether to leave the UK. In the end Scotland decided to stay, but the run up to the vote caused considerable GBP volatility.

Reflecting a more favourable economic outlook than seen in many other developed countries saw GBP rally against a slew of majors, such as EUR, JPY, CHF and AUD.  However, in line with the other majors, GBP ceded ground to USD seeing it fall decisively below 1.6000 in early November.

The spectre of deflation

On the flip side of the divergence story is Japan and the Eurozone. The big themes there were deflation–something the United States and U.K. managed to avoid. In a bid to re-inflate Japan's economy, the Bank of Japan actually increased its quantitative easing programme with JPY tanking.

Meanwhile, the Eurozone is looking increasingly Japanese with economic growth becoming harder to find and prices looking set to fall. The European Central Bank issued an alphabet soup of stimulus programmes to try and revive the Eurozone's flagging fortunes–in the short term none have made much difference. This opened a fierce debate within the ECB over launching a full scale quantitative easing programm of the kind the Fed, BoE and BoJ did.

Deflation was a major source of concern for policy makers, even in the faster growing UK there's the strong possibility that the governor of the BoE will have to write several letters to the chancellor (Minister of Finance) explaining why inflation has fallen too short of its 2% target. 

Another big story for this year is the collapse in oil prices along with that of a number of other industrial commodities–all adding to deflationary pressures in the short-term. 

About the Author

Justin Pugsley is the forex and gold markets analyst for New Zealand-based trading platform provider MahiFX. He is a keen student of markets, economics and history. Prior to working with MahiFX, Justin worked for a number of leading media organisations such as Thomson-Reuters and Dow Jones/Wall Street Journal.