Justin Pugsley - Justin has over 20 years experience writing about markets, economics and finance. He has worked for a number of leading media organisations such as Agence France Presse (AFP), Dow Jones, Wall Street Journal, Thomson-Reuters, British Sky Broadcasting and McGrawHill.
Justin Pugsley
Justin has over 20 years experience writing about markets, economics and finance. He has worked for a number of leading media organisations such as Agence France Presse (AFP), Dow Jones, Wall Street Journal, Thomson-Reuters, British Sky Broadcasting and McGrawHill.

Diverging monetary policy supports ongoing US dollar rally

If history is any guide the US dollar’s rally, which showed renewed vigour from this July, is very likely to continue for the rest of this year with increasing evidence that the US interest cycle is in the process of turning.

The US dollar is already at its highest levels since 2010 against a basket of major currencies. But such are the dynamics behind this rally that it could well go on into the first quarter of 2015.

Diverging monetary policy supports ongoing US dollar rally

But pull backs are very likely to occur - and some could be sharp given the recent pace of the rally. These
pull-backs are likely to be driven by surprises from US data, comments from US policy makers and events in other countries.

Indeed, a yawning divergence is taking place among the major currencyblocks with the chasm looking set to
widen further. The statement from the meeting of G20 finance ministers and central bank governors on Sept 20-21 picked up on this point and it appears to accept these divergent trends among the major economies.

The ministers and bankers recognised the necessity for achieving robust economic growth to help normalise monetary policy. That has happened in the US and UK.

However, it was acknowledged that there is a need to address deflationary pressures. Both Japan and the Eurozone are in that camp. There are concerns about Japan’s ability to grow and increasingly there are fears that the Eurozone is turning Japanese and exhibiting deflationary symptoms. That third point in the G20’s statement is a good description of the factors driving forex markets at the moment.


Bond market cycle has already turned

In the meantime, yields on US Treasuries have been anticipating a normalisation of monetary policy and now rising interest rates for a while. In the bond markets at least, the interest cycle has already turned upwards, which is reflected in rising yields. By the time the Fed does make its move, higher rates should well and truly be baked into exchange rates.

The two year note has seen yields rise steadily from just over 0.2% in July last year to around 0.6% in late September – it’s their highest level in three years. Shorter dated paper tends to be the most sensitive to changes in interest rates.

Also, US Treasuries yields across the curve are significantly higher than those of Germany, Japan and a number of other developed countries. This makes newly minted US bonds, in terms of yield, more attractive to investors with the rising dollar creating an extra allure.

And the direction of the interest rate cycle is a key determinant of the US dollar’s direction. Signs of rising interest rates due to an improving economy are usually bullish for the currencies concerned.

Looking at the US in particular, there are signs that the US dollar does gain strength ahead of the first round of interest rate rises. So far that pattern seems to have been playing out strongly since July with the US Federal Reserve’s quantitative easing programme due to be wound down in October.

The forex markets have taken that as a given and the focus is now on when the Fed will start raising interest rates. Expectations are clustered around it happening sometime during the second half of 2015 with even the prospect for a move as early as Q1.


History looks like it is repeating itself

When looking back through history, the current US dollar rally looks like it is following the script. Though what happens after the Fed starts raising interest rates is less certain – a lot depends on expectations for further monetary tightening after that.

The Fed started tightening at the beginning of 1994 with rates rising from 3% to 6% during the period 1994-1995. Against a basket of currencies, the US dollar did initially rise ahead of the cycle, but subsequently fell when tightening was taking place. But from around mid-95, the US dollar began a multi-year rally.

The Fed was once again increasing interest rates over 1999-2000 when they went from 4.75% to 6.5%. A similar pattern occurred during this period with the US dollar rising ahead of the news and selling off later, but then regained its poise until the beginning of 2002, after which it went into a long-term bear market.

And the last cycle of US interest rate rises occurred over 2004-2006 when they went from 1% to 5.25%. There was also a short rally ahead of this interest tightening phase, which ultimately did not interrupt the US dollar bear market for long. It eventually bottomed out around 2008.


Yellen spells out Fed’s dilemmas

But coming back to the current interest rate cycle, this statement by Chairwoman Janet Yellen neatly sums up the dynamics, which are heavily influencing thinking within the Fed over monetary policy. The comments were made at the Fed’s August Jackson Hole gathering and also clearly mapped out the data sets for traders and investors to watch:

“If progress in the labour market continues to be more rapid than anticipated by the Committee or if inflation moves up more rapidly than anticipated, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target could come sooner than the Committee currently expects and could be more rapid thereafter.”

In other words monetary policy, and in effect the US dollar’s rally, is being dictated by events in the US jobs market and to a lesser extent, at the moment at least, inflationary levels. Though the consumer price index has been higher in 2014 than last year, and it did get above 2% over part of the summer, inflationary pressures appear to be relatively mild. A rising US dollar should act as a break on price rises.

The area where there is a certain amount of confusion and hence uncertainty over monetary policy is the state of the jobs market. At first glance jobs creation is happening at a brisk pace in the US. The US unemployment rate has fallen quickly this year to 6.1% in August compared with 7.2% a year earlier.

Non-Farm Payrolls expanded at levels of over 200,000 a month between February and July though they fell short of that number at 142,000 in August. However, that may have been an anomaly and the strength of the economy suggests NFP numbers should pick up.

Where are the workers?

But that’s only part of the story. Ifanything the headline numbers are being flattered by the fact that many Americans simply aren’t participating in the workforce anymore. There are a number of possible reasons. Some may have just given up after years of fruitless job searching to live with parents. Many older workers may have simply chosen to retire early and draw their pensions instead.

Whatever the exact reason, the US labour market participation rate is around 62.8%, compared with 66% in December 2007. The big question for the Fed is whether those ‘drop-outs’ will come back into the workforce now that there are more job opportunities. Because if they don’t, wage inflation may not be far off and that will certainly have consequences for US monetary policy and the US dollar.

On the other hand if the labour participation rate does start increasing that should dampen wage pressures
for a while. A clearer picture should emerge over whether this is a cyclical or structural
phenomenon over the course
of next year.


Dramatic swing in US energy position

One very positive factor for the US dollar, which has put money in the pockets of all consumers is the fracking revolution. Gas prices, in particular, have fallen significantly in the US and are much lower than in Europe or Japan. It’s a major boost for an energy intensive country and for high energy consumingindustries, such as chemicals and metals manufacturing.

Fracking has also lowered oil prices, but not by nearly as much as that market is much more driven by global factors. But thanks to this technology, the US is now world’s largest oil producer having overtaken Saudi Arabia.

Fracking has also lowered oil prices, but not by nearly as much as that market is much more driven by global factors. But thanks to this technology, the US is now world’s largest oil producer having overtaken Saudi Arabia.

However, there are some negatives for the US. Though the Fed has clearly been preparing the markets for firmer interest rates, it still remains cautious. Pay rises are running at relatively moderate levels suggesting there is still some slack in the broader jobs market.

The Fed is guiding GDP growth for this year at 2.1% and 2.8% for 2015, which is a lowering of previous forecasts.

But the most interesting indicator could be coming from the bond markets. Whilst the yield on the two-year note has risen sharply, the yield on the 10-year bond recently steadied and even fell slightly. Though the long end tends to be less volatile – it could be signalling that US interest rates may not rise by that much, maybe to just 1-2%, before they start slowing the economy.

Getting the US economy where it is today has required a colossal amount of monetary stimulus, the most in history, yet the recovery has been far from spectacular and is in fact weaker than previous
ones. The underlying implication is that the US may not be able to grow without very cheap money, and if so, that would be a negative for the US Dollar. Wage rises and NFP data over the course of the year will provide some clues to the forex markets if this is the case.

Eurozone is faltering

However, the US dollar’s exchange rate is not driven by US events alone, but also by trends occurring in other countries. The most important exchange rate is EUR/USD and current trends in the Eurozone suggests the Euro has further to fall.

The August inflation figure for the Eurozone was just 0.4%, having fallen almost continuously since July 2013 when it was 1.6%. This suggests the Eurozone is very close to experiencing deflation, which European policy makers are very keen to avoid. Eurozone unemployment levels at 11.5% continue to be unacceptably high.

The European Central Bank is already on the case as it is talking down the Euro, cutting interest rates and has announced a stimulus programme, which involves buying up repackaged debt to give banks more leeway to lend to the private sector.

However, these measures are very unlikely to suffice in stemming the region’s deflationary pressures.

The ECB will probably, German politics permitting, be steadily dragged towards quantitative easing. And given the Eurozone’s deflationary pressures it is likely that it will need to be on a scale similar to Japan and the US to really move the dial on prices. By the end of the year, the EUR/USD rate could hit 1.2500-1.2600.

Sun could be setting on Japan – again

Japan is ahead of the Eurozone in terms of monetary stimulus, but behind the US and the UK. Quantitative easing is nothing new to Japan having been used in the early 2000s.

However, QE was really deployed in a big way after Shinzo Abe took office as Prime Minister for the second time in December 2012. Since then it has become a key tool of economic policy. It has significantly weakened the Yen, as intended, rekindled some economic growth and pushed up domestic prices.

sales to 8% from 5% in April the economy has faltered. It remains to be seen if this is a temporary or structural issue. The chances are that it is structural due to Japan’s rapidly ageing population, which is sapping the country’s economic dynamism.

In the short term that will probably ensure QE carries and could be stepped up, should the economy fail to recover. Against the US dollar, the Yen is likely to be trading around 110.00-115.00 by the end of the year.


UK in synch with US interest rate cycle

In terms of monetary policy the UK is in synch with the US. The UK economy is growing by around 3%
and unemployment is falling, though wage growth remains lacklustre. Also, UK government bond yields have risen mirroring their US equivalents.

The Bank of England has already ended its quantitative easing programme with interest rate rises expected as early as Q1 2015. This should give the Pound some support against the US Dollar. By the end of the year GBPUSD is likely to trade around 1.6500-1.6600.

Though the US recovery is hardly spectacular and the potential for interest rate rises may appear limited, it is nonetheless still better than what is occurring in many other advanced economies. This alone should carry the US dollar higher for a while longer.

This article was featured in FX Trader Magazine October-December 2014.

You can read more posts from Justin in our Market View..

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