Divergence

To diverge (definition):

1. To move, lie or extend in different directions from a common point; branch off.

2. To turn aside or deviate, as from a path, practice, or plan.

‘Divergence’ has become the new ‘risk-on / risk–off’.  In other words, every of piece of economic data, each fluctuation in the exchange rate, and every basis point of movement in interest rates is now evaluated on the basis of how well it fits into the theme of diverging monetary policy around the world.  The US is tightening, emerging markets are tightening more, the Europeans are cutting (and will soon be printing), and the Japanese are printing like maniacs. 

The interesting thing about themes in the financial markets is that they encourage what is known as confirmation bias.  In other words, data and information which supports the theme (in this case, good US data, bad European data etc.) is weighted more heavily than data which contradicts it.  An example of this occurred on Friday when both UK and US manufacturing PMIs underperformed expectations to about the same extent; the UK underperformance was quickly picked up on as further reason why the BOE would delay raising UK rates, while the US underperformance was largely ignored.  GBPUSD ended the day almost 3 cents lower…

2015 will see the ‘divergence’ theme continuing, and likely growing stronger, at least for the first half of the year.  This will work against the euro and the yen primarily, and the main beneficiary will be the US dollar…      

 

 

US Dollar Strength

“Dollar strength is going to be a theme well into next year and maybe even longer”

Scott Mather, co-Chief Investment Officer, PIMCO

December 19th, 2014

The theme of USD strength is very closely related to the theme of divergent monetary policy.  However, we believe it deserves its very own paragraph, as there are at least three other important reasons why we expect the USD to continue to get stronger this year:

  1. Valuation – Despite its recent strength (the USD gained against all 31 of the world’s most-traded currencies last year), the dollar still looks pretty cheap on a fundamental basis (calculated using purchasing power parity). In fact, of the USD remains undervalued against all of the G10 currencies except the euro and the yen.
  1. The dollar’s ‘safe-haven’ Status – The risks of a broader market correction in 2015 appear quite high. We are already about five and a half years into an economic expansion (the average post WWII expansion being just under 5 years) and certain markets, particularly US equities (see chart), are starting to look toppy. An equity market correction in 2015 should provide further support to the US dollar.

Chart: S&P 500 Index

 Chart 1

  1. Technical – As we noted back in November (link), the technical picture for the USD is looking increasingly bullish. Whilst we are somewhat skeptical about the degree to which forecasts, especially longer-term ones, should be based upon historical pricing patterns, we do agree that we could be seeing a potentially key turning point in a long term USD downtrend.

 

 

Volatility

We have predicted a return to volatility before, and been very wrong.  However, we have only seen FX volatility decrease to the levels which we saw last year on two previous occasions.  Both of these occasions were followed by dramatic spikes, as over-extended, over-leveraged positions (often carry-trade related) that were allowed to accumulate due to the low volatility had to be rapidly unwound, creating a positive feedback loop of increasing volatility and the unwinding of open positions (which are adversely impact by this volatility).   

For 2015, we expect increasing volatility (in FX, and also in other markets, such as commodities and equities) to become an increasingly important theme – to the benefit of risk seekers (speculative currency traders) and to the detriment of hedgers. 

Chart: JP Morgan Currency Volatility Index

 Chart 2

Oil Prices

Unsurprisingly, oil prices were a constant focal point in the financial press throughout the second half of 2014 after Brent Crude fell from $112 per barrel in June to its current low just above $55 per barrel. A combination of increased supply and reduced demand was initially to blame and the political standoff between oil producing countries, with everyone refusing to cut production has resulted in prices continuing to fall.

Clearly there are winners and losers from this scenario, the winners being the [primarily] developed market economies who rely heavily on importing fuel (Europe, China, Japan, etc.) while the oil producing countries (Russia, Saudi Arabia, Canada, etc.) all suffer a significant drop in export revenue. Overall though, most economists seem to agree that from a global economic perspective, lower oil prices will aid the recovery as it frees up cash for both consumers and businesses to spend elsewhere.

Chart: Brent Crude Prices

 Chart 3

 Across the globe, the falling oil price poses an interesting dilemma for central bankers. On one hand, Russia has hiked interest rates to 17% in an attempt to stem the capital outflows from the country. Meanwhile, falling inflation in countries that import oil is prompting has reduced the need for those central banks to tighten policy.

Possibly the most extreme example of this is the Eurozone where the ECB has seen headline consumer prices fall steadily throughout 2014. Granted there are other factors at work other than just oil prices, but in the short term, the ECB are focused on easing policy as opposed to tightening. In the UK, falling inflation has resulted in expectations for the first MPC rate hike to be scaled back until Q4 2015. If oil prices remain steady at current levels (or fall further) and expectations for tighter policy continue to be scaled back, we can expect the respective currencies to remain under pressure based on current correlations.

Emerging Markets

Throughout 2014, two key influences have weighed heavily on emerging markets, the first being the oil price and the second being the outlook for US monetary policy. The tapering of QE3 has reduced the amount of capital flowing into emerging markets as investors hunt for yield. In fact, the prospect of higher rates in the US has resulted in funds flowing out of emerging markets and back into the US resulting in a snowball effect where the dollar continues to strengthen while the EM currencies remain under heavy selling pressure. The table below shows the emerging market currencies that have been hit hardest in 2014:

Russian Rouble

-76.46%

Argentinean Peso

-30.72%

Columbian Peso

-22.68%

Hungarian Forint

-22.38%

Polish Zloty

-18.00%

Chilean Peso

-15.98%

Czech Koruna

-15.12%

Looking forward into 2015, there seems little scope for change anytime soon. The Federal Reserve are widely expected to begin raising interest rates later this year (recent economic indicators suggest that the US recovery remains relatively robust) and for now, there is little sign of oil prices recovering their recent losses with Saudi Arabia seemingly intent on maintaining production at current levels. In this scenario, economies with a relatively small exposure to external debt should fare better, together with those which are net importers of oil.

 Authors: Kevin Lester and Marc Cogliatti