Having been more downbeat on H1 2015 prospects for the US economy, it was only natural that we would expect the Fed to start raising interest rates later, and that the US Dollar would undergo a period of consolidation following the strong gains in the second half of 2014 and early 2015. Our roadmap was that the Dollar correction could last for most of Q2 as the US economic data continued to disappoint and the Fed were forced to lower their forecasts. We continued to believe in the longer term bullish Dollar story, and our correction call was really just short term tactical positioning.
Although it appears that Q2 US growth will indeed be below the Fed’s quite optimistic forecast, events appear to have changed this week, and we are altering our roadmap. We think that the next leg of the US Dollar bull market has begun already, and we have started to increase our bullish exposure. Over time, we expect the Dollar strength to be broad based as it was last year. However, it would appear that weakness in the Euro is kick starting the bigger Dollar bull market back to life after the ECB announced its intention to front load QE and do more if necessary.
We may hold different views to central bankers in terms of economic forecasts and just how successful their policies are in promoting economic growth and how painful the unintended consequences will be in the fullness of time. However, we do know that we need to listen carefully when they signal policies to markets. Ever since he took over control of the ECB, Mario Draghi has fought successfully to bring down bond yields in the periphery (with his now famous “I’ll do whatever it takes and believe me it will be enough” comments in mid 2012) and since early 2014 he signalled clearly to the FX market that he wanted to see the Euro meaningfully weaker. We can only surmise that Draghi was extremely irritated by the recent rise in bond yields and the Euro.
And so it was that Benoit Coeure stepped up to the plate this week and announced (privately first and publicly the next day) that the ECB will be looking to frontload their QE and that interest rates could go further into negative territory. Coeure was quickly followed by fellow ECB board member Christian Noyer who confirmed QE could be extended if needed. This is clear central bank speak that they do not want the recent rise in yields and the Euro to continue, and as can be seen in the chart below, the Euro suffered a poor week – in fact the worst week percentage wise since the peak at 1.40 last year.
Of course, for the Dollar to exhibit broad based strength, the Fed will have to “sanction” this through tighter monetary policy which will bolster the Dollar whilst all other major central banks are either easing or talking easier policies.
We have been repeatedly told by the Fed this year that they will be data dependent, and with our view that growth will be weaker than expected, we still think that the first rate rise could be delayed until 2016. However, Chair Yellen spoke again this week and confirmed that the Fed “must make policy in a forward looking manner…delaying action to tighten monetary policy until employment and inflation are already back to our objectives would risk overheating the economy…For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target”.
The Dollar strengthened markedly against all G7 currencies and was strong against most Emerging Market currencies as well. This broad strength adds to our conviction that the Dollar bull market has restarted. We expect the Dollar to strengthen versus currencies where QE is seen, commodity currencies and selected EM currencies. The chart below shows the Dollar performance against the Japanese Yen, and after a strong week last week, it appears that a 6 month consolidation is now over and we should expect further Dollar gains here too (of course supported by divergent monetary policies between the two central banks).
We think that the major central banks continue to send strong signals that their policies are diverging and that currency realignment is necessary to support growth where structural problems persist. Despite our own concerns that US growth may not accelerate as quickly or robustly as the Fed is predicting, we still expect rates to rise there at some point, and so we are taking these central bank messages at face value. We are now bullish the Dollar again and expect another broad based rally to be seen in the months ahead.