- The Japanese yen rose to its highest level in four months against the dollar on Wednesday in Asia, prompted by greater skepticism among investors about whether President Donald Trump will be able to stimulate the U.S. economy.
- The potential for trade friction following a weekend meeting among the Group of 20 industrialized and developing nations also clouded the global economic outlook and boosted the appeal of the yen, a safe-haven asset in times of economic uncertainty. At the request of the U.S., finance ministers in the G-20 dropped a longstanding clause criticizing protectionism.
- The yen rose against the U.S. dollar in the hours immediately after Mr. Trump’s election victory, then fell sharply on expectations for an economic-stimulus policy in the Trump administration.
- The president has promised to introduce tax cuts and spur $1 trillion in spending on U.S. infrastructure construction, but he hasn’t outlined a detailed plan.
- Expectations for the changes began to weaken after Mr. Trump struggled to round up support for a health-care bill headed for a vote this week in the Republican-led House.
- Japanese Finance Minister Taro Aso on Wednesday said Tokyo should maintain close communication with the U.S. and continue its efforts to keep the yen stable. “Excessive sharp movements, up or down, could have a considerable impact on the economy,” Mr. Aso said in Parliament. He brushed aside speculation Washington might pressure Tokyo to guide the yen higher.
- Until recently, the widening interest-rate gap between the U.S. and Japan was supporting the dollar. The Federal Reserve has been raising rates while Japan’s central bank has been keeping the yield on 10-year government bonds close to zero. However, when the Fed raised its benchmark rate last week, its projections for further tightening disappointed some investors who had bet on a faster tightening pace. That led to drops in Treasury yields and some dollar selling.
- The Japanese yen hit a four-month high against the greenback on Wednesday, complicating the export-oriented country’s efforts to weaken the currency.
Jitters over President Donald Trump’s ability to push through pro-business policies triggered a sharp stock sell-off on Tuesday and sent investors scrambling for haven assets.
- The flight for safety continued on Wednesday, sending the yen 0.9 per cent higher to 110.76 per dollar.
- That’s its strongest level since November 18, extending the currency’s gains so far this year to over 5 per cent.
- The dollar’s retreat comes amid mounting nervousness over a key vote in Congress on Thursday over Mr Trump’s plans to dismantle Obamacare.
- Signs that the president might not be able to rally the support needed to pass the bill have raised questions over whether he would be able to deliver on the expected tax cuts, stimulus spending and deregulation that have powered stock markets to record high after high this year.
- The dollar has been also been pressured by unexpectedly dovish comments last week from the Federal Reserve over the pace of future interest rate hikes.
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.
- Federal Reserve officials this week signaled that the end is near in the difference between Australian and U.S. interest rates, which has been positive since 2001.
- As the Fed raised short-term rates by a quarter percentage point on Wednesday, it projected two more such increases in 2017: If it carries through, the upper end of the target range for U.S. rates will be 1.5% by the year’s end—where Australia’s benchmark rate is now.
- The closing U.S.-Australian rate gap is a standout example of a trend currently looming over foreign-exchange markets: the narrowing difference between U.S. and global interest rates. While the Fed is now in tightening mode, many central banks that have long had higher benchmark rates—such as those in Australia, India and Brazil—are on hold or cutting.
- Currency players often seek to profit from interest-rate gaps, known as the “carry,” by investing in stocks, bonds and currencies in countries with higher rates. Now, rising U.S. rates could trigger a reversal of such capital flows, which could prove destabilizing for countries that had benefited from the search for yield during the years when U.S. rates have been ultralow.
- Moves in the euro in 2014 show how changing interest-rate differentials can result in bad blood for currencies.
- The European Central Bank pushed its key interest rate negative in June 2014, while the Fed’s target range for its benchmark rate stayed between 0% and 0.25%.
- The gap between the two regions’ rates has since widened, as the U.S. has started tightening. The euro dropped 12% against the dollar in 2014, 10% in 2015 and 3.2% in 2016, according to Thomson Reuters data.
- Some investors are sanguine about the impact of narrowing interest-rate gaps, arguing that other factors can influence currencies. A rebound in commodity prices and solid economic data in China, a major trading partner, have brightened Australia’s outlook, helping propel the Aussie to a gain of 6.5% this year against the U.S. dollar.
- And even as the Fed pushes ahead with rate increases, the currencies of some countries could remain attractive as their interest rates remain much higher, investors and strategists say.
- They recommend owning high-yield darlings like the Indonesian rupiah and Indian rupee, where benchmark rates are 4.75% and 6.25%, respectively, providing a substantial buffer against rising U.S. rates.
- The Federal Reserve may be well set on its interest-rate raising course this year, but gains in the dollar could prove harder to come by.
- The key reason why the dollar’s gains are slowing: The U.S. is no longer the sole bright spot in the global economy.
- Sure, the world’s largest economy has recovered enough for the Fed to start normalizing interest rates after years of near-zero levels.
- But the eurozone is now growing faster than the U.S.
- In Japan, where officials have resorted to unorthodox measures in the past five years to stoke inflation, prices are finally rising slightly.
- Both the Bank of Japan and the European Central Bank left monetary policy unchanged at their latest meetings.
- In China, economic data has been solid so far this year.
- Dollar’s losses after the Fed raised overnight rates seems to contradict common economic wisdom, which dictates that as the U.S. raises rates before other major global central banks, the divergence should boost the dollar. Higher interest rates tend to boost the allure of a country’s assets, which in turn tends to attract capital.
- While that may yet prove true, the U.S. currency’s already sizable advance since 2012 may lead to diminishing future returns, some investors say.
- The ICE U.S. Dollar Index has risen each year since 2012. The bulk of the rally happened in 2014 and 2015, when the index advanced by 12.8% and 9.3%, respectively; in 2016, it gained 3.6%. More than half the index’s weight comes from the euro, followed by the Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.
- The scene was different during the great dollar surge of 2014-2015. While the Fed had just started winding down its post-financial crisis bond-buying program, central banks in Japan and Europe were busy buying up government bonds to stimulate their persistently sluggish economies, keeping bond yields low globally.
- The yearslong move higher in the U.S. dollar has left it looking expensive. One gauge of a currency’s value is its real effective exchange rate, or REER, which measures a country’s exchange rate against several trading partners, adjusted for inflation.
- The dollar’s REER is currently higher than both its five- and 10-year averages, according to the Bank for International Settlements. While currencies can trade above and below their long-run valuations for extended periods, it underscores the extent of the dollar’s rally.
- Meanwhile, the real effective exchange rates for both the euro and yen are below their five- and 10-year averages, suggesting they are cheap.
- For sure, there are other factors that could push the dollar higher this year.
- Changes to U.S. tax policy, especially any that provide incentives for companies to bring the cash they have stashed abroad back into the U.S., could yet be a game changer for the dollar. If U.S. companies repatriate those earnings, the resulting flow of money could boost the dollar regardless of the economic outlook. President Donald Trump has talked about lowering the corporate tax rate, and his Treasury Secretary Steven Mnuchin has laid out plans to overhaul the tax code by August.