The single most significant market trend of the last two years was U.S. dollar strength. The trend will persist and even accelerate in 2016. Intentionally or not, central bank policies will allow nothing else.
Consider what is happening in major capitals:
- In Tokyo, Prime Minister Shinzo Abe’s “Abenomics” plan is creating enormous liquidity but no inflation, which was the whole point. Lacking any other tools, the Bank of Japan can do little but double down on the plan. Expect even more quantitative easing this year.
- In Frankfurt, European Central Bank head Mario Draghi is keeping his promise to do “whatever it takes” to preserve the euro. The ECB is buying every bond in sight and imposing negative interest rates. Yet like Japan, it is having little impact on the inflation rate. Expect even lower negative rates and, because the ECB is running out of bonds to buy, they will soon move to other assets.
- In London, the Bank of England’s task is not quite as difficult as Draghi’s, but challenging nonetheless. Years of low rates helped the economy deleverage but have not sparked much recovery. Inflation is as non-existent in the UK as it is in the Eurozone. The BoE would love to hike rates, but has little room to do so.
- Beijing is beaming with pride after the International Monetary Fund said it would add the renminbi to its reserve currency basket in late 2016. This will help sustain deposit rates that are already higher than prevail in the other four Special Drawing Rights (SDR) currencies (USD, GBP, EUR and JPY). But to get into the SDR they had to pledge to move toward floating the renminbi. Oops. Watch the currency go down in value, not up.
Now contrast all these central banks with the U.S. Federal Reserve. For all their “data dependent” talk, Janet Yellen and others clearly want to hike rates. They fear that they are losing credibility with the markets.
The Fed will get off zero, but not go much higher. The other central banks have them boxed in. The dollar is strong because our yields, while paltry, are more attractive than the alternatives. The higher they go, the stronger the greenback will get. Dollar strength has already hit earnings hard at U.S. multinationals. Rate hikes will make American exports more expensive to the rest of the world.
Faced with this dilemma, the Fed will impose one or two small (25 basis points) rate hikes and then pause for a considerable amount of time, probably until 2017 when a new president takes office (see “Cautious Fed)”.
Whether the Fed pauses or not, the U.S. dollar will remain relatively more attractive than any other currency. This will be the single most important factor for financial markets in 2016.
Central banks are on their own. While each central bank does what makes sense for its own constituents, their choices will create huge collateral damage elsewhere. The strengthening dollar will make dollar-denominated debt harder to repay for many emerging market nations. The consequences for those highly leveraged economies will create stress elsewhere. How the world handles this stress will be the story of the year. Smart traders will watch it closely.