As we predicted in January of 2015, the U.S. dollar (USD) experienced a bull market last year. That significant rally was surprisingly broad. In my recent Pioneer Blue Paper, U.S. Dollar Bull Market: Moving into Overshoot Territory in 2016, we examine three themes that we believe are likely to play a key role in the 2016 currency markets. The first is the divergence in G-4 monetary policies.
USD Transitioning to a Pro-Growth Currency
We believe there will be sharp divergences in G-4 monetary policies that will serve as major drivers behind a USD bull market in 2016. This theme resonated in 2015 due to aggressive easings by the European Central Bank (ECB) and the Bank of Japan (BoJ) with the Federal Reserve (Fed) tightening cycle pushed off toward the end of the year and later than expected. In 2016, we expect the start to the Fed’s tightening cycle to be the single most important factor behind a stronger USD.
On December 16, 2015 the Fed embarked on its first tightening cycle since June 2004 by lifting the Federal Funds rate by 25 basis points (bp) to 0.50%. The Bank of England (BoE) is expected to keep monetary policy unchanged in 2016, but it could be a very close call. The BoJ and the ECB are both expected to continue quantitative easing (QE) in 2016, but it is unclear whether we will see additional monthly purchases or further rate cuts. We believe the ECB is more likely to do more QE.
The Federal Reserve’s Tightening Cycle
Benchmark interest rate differentials are likely to provide a positive structural tailwind for the USD. The market-implied rates suggest the Federal Reserve will hike 25bp by the end of 2016 (See chart). On the other hand, the ECB, BoE and BoJ have essentially a flat trajectory next year. Overall, interest rate differentials will move strongly in favor of the USD.
However, there remains a discrepancy between Fed projections on rate hikes and market expectations. The Fed is forecasting four rate hikes next year, while the market is pricing in only one hike. The extent and depth of the USD rally will depend on the pace and trajectory of the U.S. tightening cycle. In the chart below, Scenario 1 represents the current market expectations of one rate hike and we see a modest differential between the U.S. and G-3 ex-U.S. Under this scenario, the USD is likely to appreciate mildly against G10 currencies. However, if improvements in the labor market continue as expected, there will be a complete disappearance of spare capacity as the unemployment rate falls well below the non-accelerating inflation rate of unemployment (NAIRU) – a threshold that usually coincides with wage pressures.
In addition, inflation is expected to move closer to the Fed’s inflation target of 2.0%, with risks skewed toward the top side. Any one of these developments will vindicate the Fed’s projections of four rate hikes, prompting a repricing by the markets, (Scenario 2). This scenario has a large differential of 148bp between U.S. and G-3 ex. U.S., which will lead to a sharp, broad-based acceleration in the USD rally.
Either scenario helps to support the USD. Therefore, with the start of Fed rate normalization, we looked at USD performance during the last six Fed tightening cycles since 1977. Our analysis has found that, on average, the USD TWI has appreciated 4.3% since 1977 and 5.0% since 1983 during the duration of the tightening cycle. Interestingly, the 2004 Fed tightening cycle was the only one where the USD did not appreciate and actually declined 6%. Our research has also highlighted that the USD rally has legs going out 12 months from the start of the tightening cycle. On average since 1983, the USD TWI has appreciated in the 3-, 6- and 12-month periods into the tightening cycle by 1.3%, 2.1% and 4.4%, respectively. We have no reason to think the USD rally has run its course, particularly since there remains a high degree of uncertainty over the trajectory of the Fed’s tightening cycle with little to no chance of monetary tightening by the ECB and BoJ.
Impact of Negative Rates — A Structural Headwind?
While the Fed tightens policy, what happens with negative interest rates, particularly in Europe? Negative benchmark interest rates by the Danish, Swedish, Swiss and European central banks are having a big impact on short-term interest rates. These benchmark interest rates have effectively become a magnet for 2-year yields. In all cases, 2-year yields have converged to around the bottom end of the benchmark interest rate.
We suspected that when 2-year yields were nominally positive, their impact on the exchange rate was inconsequential, however, as 2-year yields became negative, they were having a depressing effect on the exchange rate.
To test this theory, we ran a regression analysis between German 2-year bund yields and the euro (EUR)/USD exchange rate.2 Our quantitative analysis revealed two insights. First, the results seem to confirm our suspicions, as the R-squared value was an unimpressive 0.46 when the German 2-year yield was positive, but a robust 0.85 when rates were negative.3 Second, our regression analysis showed that, should German 2-year yields drop to -0.40%, the EUR should hit 1.00. As of December 31, German 2-year yields stood at -0.35%. It should be noted that it is no easy task for the German 2-year yield to move from -0.35% to -0.40%.
EUR — A run toward 1.00
We anticipate the EUR will test parity at some point in 2016. Inflation expectations remain below the ECB’s inflation target with risks of it becoming unhinged. We are forecasting growth slightly above trend in Euroland, however any signs of growth falling short could put pressure on the ECB to ease further. We project that another cut in the deposit rate would send German 2-year yields at least to -0.40% and prompt a test of 1.00.
1 Source: JP Morgan, 12/31/15. Data is latest available at press time.
2 Regression Analysis is a statistical process for estimating the relationship among changes variables.
3 R-Squared (R2) represents the percentage of the portfolio’s movements that can be explained by the general movements of the market. Index portfolios will tend to have R2 values very close to 100.