Currency markets offer the perfect antidote to confident forecasters. The overwhelming consensus before Christmas was that the dollar was setting off on an early-1980s-style bull run, and investors should grab hold while they still could. The euro would fall to parity, and emerging markets needed to brace for turmoil as dollar debts would become harder to service.
Three months later, the dollar’s weaker, the euro (and the less-discussed yen) is up strongly, and emerging market stocks and currencies have leapt.
Understanding what went wrong with the forecasts is vital in pinning down what might happen next. But more important for the longer term are the Federal Reserve’s predictions of weak growth forevermore—and whether it is merely projecting the recent past into the indefinite future.
There were three major drivers of the dollar’s reversal. First and probably most important was that the dollar had become a crowded trade, with pretty much everyone believing it would carry on up. Bets on dollar futures had rarely been higher, and the consensus in favour of the dollar was strong.
Underlying this positive sentiment were two fundamental arguments, neither of which has so far worked out: Central bank divergence; and U.S. tax policy.
The Fed’s December increase marked the resumption of its interrupted rate cycle, while the central banks of Europe and Japan were stuck with hopeless economies and no inflation, and so wouldn’t raise interest rates in the foreseeable future. Investors were also convinced that the Republican-controlled House proposal for a border-adjusted tax would restrict imports while helping exports, giving a boost to the dollar.
As the year has worn on, all three forces behind the dollar’s reversal have come under pressure. The crowded positions have unwound somewhat, most obviously in speculative bets on dollar futures. Signs of inflation and faster growth have shifted the European Central Bank out of easing mode and talk of a European “taper” has begun. And the border-adjusted tax has been questioned by the White House and run into opposition from several Republican senators.
There have been only small shifts in economic forecasts, but they’ve been in the wrong direction for the dollar. The average prediction collated by Consensus Economics for U.S. growth has dropped from 2.3% to 2.2% in the past three months, while for Japan, the eurozone, U.K. and Canada, they have risen by 0.1 to 0.2 percentage points.
A bet on the dollar now could be based on the eurozone’s inability to raise rates much, if at all, without threatening the solvency of its weaker members. It could be based on Japan’s commitment to hold long-term rates at zero, ruling out an end to bond buying. It could even, less plausibly, be based on the border-adjusted tax being accepted by the Senate.
But for the long-term strong dollar bet, look to the Fed. The central bank is assuming the economy will experience a version of “secular stagnation”, popularized in recent years by former Treasury secretary Larry Summers. From this perspective, long-term growth will be weak, too much will be saved, and the “natural” interest rate will stay low. The dollar could still rise if the rest of the world is going to be even worse, but it’s hard to be truly bullish because the assumption of weak, long-run growth makes the Fed err on the side of lower rates.
At last week’s Fed meeting, policy makers held their long-run growth predictions for the economy at 1.6% to 2.2%, with a median forecast for long-run interest rates of 3%, equivalent to just 1% adjusted for inflation. Back in 2012, with the Lehman crash still fresh in the memory, the lowest Fed growth forecast was 2.2%, and the median expectation for long-run interest rates was above 4%.
“All these years they’ve had these bullish views and they’ve had to downgrade,” says Stephen Jen, co-founder of Eurizon SLJ Capital. “Now just as the world economy seems to be gaining traction they are moving the other way.”
Put another way, the Fed’s economists may have fallen into the classic psychological trap of recency bias, putting too much weight on the postcrisis period. The history of secular stagnation suggests the Fed’s far from the first to assume the good times are gone forever.
The term secular stagnation was coined by Alvin Hansen in 1938, on basically the same grounds as the idea is pushed today: weak productivity and population growth. He was badly wrong, as the surge in postwar technology and baby boom soon demonstrated. Patrizio Pagano and Massimo Sbracia at the Bank of Italy showed that such a mistake has usually been made when growth has been weak, with the same concerns raised in the world-wide depression of the 1870s, in the stagflation of the 1970s and again as the 1980s boom came to an end.
I don’t know if machine learning, biotechnology, robotics or even virtual reality will be the breakthrough that leads to faster growth in future. Maybe all of them will, maybe none of them. But I’m certain that it’s a mistake to put too much confidence in any long-term predictions of productivity or demographic change—and that it won’t take many good quarters of rising growth and inflation to see the Fed start revising up its expectations.