Don't Lose the Forest for the Trees: Dollar Rally Still in Early Days

Many investors appear to have lost their bearings.  It is as if the proverbial rug has been pulled from beneath their feet.  Last week's bolt from the blue by the Swiss National Bank is simply the latest in a string of significant surprises.

 The decline in US Treasury yields despite the fastest growth in more than a decade in the April-September 2014 period took many by surprise.  The collapse in oil prices was unexpected, even though the increase is US output was widely known.  It was also well known that OPEC itself was producing in excess of its quota agreement.  In late October 2014, the Bank of Japan took the market by surprise.  It decided by a 5-4 majority to dramatically increase its already aggressive easing. 

Although tomorrow's likely decision by the ECB has been well telegraphed and anticipated by investors, there are so many moving parts.  It is not unreasonable to expect a volatile reaction regardless of the particulars.

As difficult as it may be, medium and long-term investors may be best served by staying focused on the big picture.   The key element of this big picture is the divergence between the US and the rest of the high income countries.  Specifically, the policy responses to the shock of the financial crisis differed depending on numerous institutional, ideological and idiosyncratic considerations.  The different policy responses have produced different economic outcomes.  Those different economic outcomes are the critical fundamental fact that underpins our expectation for the dollar to continue to appreciate on a trend basis.

The economic and policy divergence will likely last not months or quarters, but at least a couple of years.  This implies, as we have argued before, that the dollar bull market is still in its early days.   We expect the euro to fall through parity ($1.00) next year.  We suspect before it is over the euro will approach the historic lows set in the 2000-2002 below $0.9000. 

The divergence with the UK may not be as extreme, and the BOE is bound to hike rates before the  ECB,  but that now seems to be more than a year away.  Sterling is likely to fall below $1.40. 

The dollar's performance against the yen seems somewhat less clear.    The dollar has appreciated by around 20% since the late October BOJ surprise.  Surveys indicate that many Japanese businesses do not seek a weaker yen.  Nevertheless, the power of the dollar's bull market may be sufficient to carry the greenback toward JPY130-JPY135, where it peaked in 2002. 

The Bank of Canada surprised the market earlier today with a rate cut.  The US dollar is likely headed toward CAD1.30, the high from 2008-2009.  Before the US dollar bull move is over, it can move into the CAD1.35-CAD1.40 area. 

The Reserve Bank of Australia is likely to resume its own easing cycle next month.  Despite the anticipation of these rate cuts, the slowing of China and the drop in commodity prices, the Australian dollar has not fallen below $0.8000.   We expect the divergence of policy will push the Australian dollar toward $0.7400.  

We have identified that the key policy signals from the Federal Reserve emanate from its leadership (Yellen, Fischer and Dudley).  They continue to suggest a rate hike in the middle of this year is still the most likely scenario.  If the market pushes its expectations out into later this year or even next year, it would impact the pace of the dollar's advance.  However, in the big picture, we have little doubt that the Fed will indeed raise rates before the other central banks in the G10.    

In addition, the US economy expanded above trend after the largely weather-induced weakness in Q1 14.   The consensus is for the US economy to expand by a little more than 3% in 2015.  Even if growth is a bit slower, the divergence between the US and other high income countries will remain significant. 

 There will be near-term volatility, and while currencies trend, the trends are not smooth.  There is no substitute for disciplined risk management.    That said, we see much life left in the dollar's bull trend.    On a real broad trade-weighted basis, the dollar's bull market in the late 1970s into the mid-1980s was more than 40% from trough to peak.  The rally in the mid-1990s to early 2002 was about 25%.  The rally since the 2011 record low has only been about 12% as of the end of last month-- Early days indeed.