Executive Summary
- For 2014, we were relatively close on H1 EUR and GBP forecasts, with bearishness on yen and Aussie coming good in the second half of the year.
- Both the Fed and BoE will struggle to raise interest rates next year against the backdrop of low inflation and inflation expectations.
- Next year is much more about the risks than central projections. Principally, the risks that QE in the Eurozone leads to an even greater mis-allocation of resources from ECB-sponsored asset purchases.
- The yen is the currency which we see as structurally weaker during 2015, driven by changing current account, energy and population dynamics.
- The Aussie will hold up relatively well in the first half of the year, less so in the second half.
- Gold will again find the going tough.
Forecasts – The Majors in 2015
Looking Back
You don’t need me to tell you that FX forecasting is one of the hardest games in town. I say that as someone that has spent a lot of my career in the rates and macro environment. But I also know that looking back is an important part of learning from the past and also from the logic one applied 12 months ago.
Like many, I was looking for dollar strength in 2014, although it was labelled ‘conditional dollar strength’. By this I meant that the dollar was not going to run away to the upside and especially in the first half of the year. This largely held for the first few months, with the second half of the year gains (nearly all in Q3) surpassing expectations.
In terms of the majors and looking at the quarterly forecast profile from last year as compared to consensus and actual, the best outcome was the euro. I didn’t succumb to euro negatively early on and with the steady dollar tone, this meant that H1 forecasts were fairly accurate, although this was partially offset by the extent of the weakness seen in the second half.
Sterling has been slightly onside overall, with a very good Q1 hit. The misses were the Aussie (anticipated weakness not coming through until December) and the yen, where the extent of the weakness was concentrated at the end of the year. Finally, I was a little too bearish on gold (seeing a move to USD 1,000 before recovering), but as with previous years, I felt the need to speak as this is one commodity where noise and hyperbole are offered in near unlimited quantities.
Last year, I focused on the underlying dynamics of FX markets, pointing out that we had moved to far less trended markets and this was likely to change in 2014. As always with FX, things are never smooth, so whilst that shift in dynamic did happen, it was very much concentrated in the second half of the year. The dollar had its longest weekly run of consecutive gains since the gold standard finally broke down in the early 1970s.
Ultimately though, this dynamic is difficult to sustain without moves in underlying interest rates, because this is what drives longer-term divergences on major and liquid FX pairs. So, if you think 2014 was hard, then come and meet 2015.
The Majors
Dollar – Tough Going
Ever since central banks started emergency easing measures back in 2008-09, policy-makers have struggled to know what the post-crisis world would look like. Many have called this “the new normal”. This matters for FX, because we’re at the point where we are starting to see divergent central bank policies (which have increased both volatility and trends), but if they are to continue, then it requires current assumptions to be proven correct. This has rarely happened over the past few years.
There was a pretty early agreement that the pre-crisis growth rates were not going to return, not least because to varying degrees, growth was reliant on both rising debt and also asset prices, with the two often inter-linked (especially in relation to housing). Even in the US, who have led in terms of post-crisis growth, annual growth has not once hit the 3.4% average seen in the pre-crisis period. In the latest FOMC projections released in September, not even the most bullish forecast had growth above this level next year (in contrast to the June projections).
There was also a belief that we would see policies push inflation higher, which has not proven to be the case. For the US, the Fed’s favoured inflation expectations gauge is at the lowest level for more than 3 years. At some point, we’re going to have to wake up to the fact that the ‘new normal’ has a lot more about it than simply just getting used to slightly slower growth. As for Japan, at some point we have to ask if the situation is structural, rather than cyclical and the longer it lasts, the more likely is it that the former is true.
So, even if growth does hold up in 2015 (at a slower pace vs. 2014), it’s far from clear that inflation is going to recover against the backdrop of low real earnings growth, a modestly firmer currency and a weak oil price. This is hardly the backdrop against which the Fed is likely to start signalling its intention to raise interest rates, even if by only a modest amount. As such, I don’t expect that the Fed will raise rates next year as a base scenario. If they do, then it will be at the tail end of 2015.
As previously mentioned, there is only so far the dollar can deviate from other currencies with minimal carry, such as sterling, euro (less so the Swissie and yen) so long as rates are kept steady. Furthermore, the impact of QE on currencies has diminished through time, so even if more QE is sanctioned, the impact will be far less than was the case in the early days of the crisis.
The coming year is going to move back to the 2012-13 and 2014-H1 tendency for shorter trends and tighter ranges. It means that macro trend-following strategies will once again find it tough going. So whilst our headline forecasts may appear ‘boring’, the dollar will be anything but if you are taking a longer-term view.
Euro – Down but Certainly not Out
Twelve months ago, being bearish the euro seemed to be an easy win. As ever though, things are never clear cut with the single currency and the same holds true as we enter 2015. The ECB has essentially said that QE is only a matter of time and form.
But make no mistake, this is going to be very different to the QE we saw early on in the crisis from other central banks. There are two principle channels by which QE works. The first is the reduction in interest rates further down the term structure, driven by the fact that short-term rates are near or at their zero lower bound.
The second is the so called portfolio balance effect, by which investors buy other assets from cash released from the sale of securities to the central bank, so equities, commodities etc. Naturally, both channels are pretty saturated. Germany 5 year yields are just a few basis points. Italy and Spain are below 1% on the same term to maturity. Historically, these are unprecedented levels.
When the UK started QE in March 2009, the UK 5 year was around 2.50%, reaching a low of 0.50% in mid-2012 (currently 1.35%).
As well as the reduced impact of QE, there is also the question of efficacy. One of the issues pre-crisis was the mispricing of sovereign debt, with Greece and others yielding only a handful of basis points above Germany. We’ve already seen an unprecedented rally in peripheral debt, helped by Draghi’s promise to “do whatever it takes” back in 2012.
Should the ECB go down the road of buying sovereign bonds, they could well be presiding over an even bigger mispricing of risk. Furthermore, will it prove to be the push towards structural reform which the ECB and Germany want to see? In all likelihood, it won’t, because governments are now able to fund at very affordable levels.
The important question is how this will impact the currency. I don’t see the currency becoming the funding currency of choice, in part because carry opportunities have diminished recently, not least in emerging markets. Also, there remain structural supports to the single currency, in the form of the mildly positive and improving current account surplus.
Sterling – Dragging Behind
In a relative sense, sterling has been through the wars during 2014. Teased higher by the central bank into the middle of the year, only to be squashed by the subsequent dollar rally and the fall in domestic price and wage indicators, scuppering the risk of a rate hike before year-end.
The year ahead could be just as troublesome. Don’t forget, cyclically at least, the UK is more aligned to the US in the era of post-crisis dynamics. From the pre-crisis peak in output in 2008, Germany’s output has been above the UK for the most part, but the UK overtook in Q3. With our base case being no increase in rates from either central bank, then cable is likely to be on the choppy side during 2015.
The risk to this view is more for a slightly firmer dollar, which would push cable below the 1.50 area towards the second half of the year. It’s not as clear that sterling will be able to outperform the single currency, which as we explained above, is not set to fall out of bed on the back of quantitative easing from the ECB.
And then there’s the small matter of an election in May 2015. The rise of the non-core parties (principally UKIP) means that it will be very hard for a single party to gain overall control of parliament. The result will be either another coalition or a single party pushing ahead with no overall control and the sluggish policy-backdrop that will entail. A dysfunctional political system has not undermined the dollar, but it remains a risk for sterling in 2015.
Yen – Tempered Depreciation
Looking for yen weakness was the most frustrating theme of 2014 and when it finally came, many had already given up on it. Welcome to trying to trade the yen. For 2015, structurally at least, I feel more confident in the view that further weakness is set to ensue, but as ever it’s not going to be a one-way street north on USDJPY.
The primary pillars of support for the yen are weakening. The consistent current account surpluses which built up Japan’s huge net overseas investment position are now a thing of the past. Furthermore, Japan is slowly and belatedly waking up to the fact that it has to be more aggressive in its investment strategies if it is to have any hope of meeting its pension commitments in coming years.
As such, as has been the case for probably two years now, the yen cannot be viewed as the safe haven currency it once was. The issue for Japan is that structural changes on both the energy side (net importer) and also manufacturing (much shipped overseas) have reduced the positive impact of the weaker yen which has been so craved during the depths of the crisis years. As always, you have to be careful what you wish for when it comes to the yen.
Aussie – Holding Up, but not Forever
My Aussie forecasts have come good into year end, but that’s a long-time in FX. What was noticeable earlier in the year was the resilience of the Australian currency in the face of weaker news coming out of China. We’d noted before then the falling dependence of the Aussie on events in China and also commodities. If this shift had not happened, then the Australian currency would be a lot weaker now.
As it is, the central bank has kept rates steady, kept up its rhetoric on the currency, although tempered it from what we were hearing at the end of 2013. We expect 2015 will be a year of two halves- steady for the first half, lower for second.
Gold – Sense Prevails for Now
I’ve written less about gold this year, vs. the previous couple of years. As a non-yielding asset with relatively inelastic supply, there is no great theory as to what should determine the price, so the floor is open to a lot of bunkum and crazy stuff to be written. This has largely driven my previous analysis on gold; i.e. a need to refute at least some of it.
As mentioned, last year I was relatively bearish for 2014, perhaps a little too much, but overall the sentiments proved largely correct. In a world of low inflation and a steadyish dollar, gold is going to struggle once again. This should ensure the 1,100 to 1,350 range holds for the first half, but gold is likely to come under pressure in the second half of the year.
That won’t stop some completely outlandish things being written on gold, but at least I’ve said my piece.