By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
December has been a busy month for central banks. First the ECB expanded Quantitative Easing, then the Reserve Bank of New Zealand cut interest rates by 25bp. And, of course, this week the Federal Reserve raised interest rates for the first time in 9 years. Then on Thursday night, the Bank of Japan surprised the market with fresh easing.
Investors have been calling for the BoJ to increase the size of its QE program for months but BoJ Governor Kuroda refused, despite ongoing weakness in economic data because he saw the underlying trend of inflation moving higher and felt that the weak yen would help move inflation closer to target. Yet at this year's last central bank meeting, the BoJ decided to get onboard with policy changes. It announced a new 300B-yen program to buy exchange-traded funds and extended the duration of JGB purchases to 12 from 10 years. USD/JPY spiked to 123.50 on the initial announcement but dropped to 121 in the hours that followed -- a sign that FX traders were disappointed by the announcement. At 300B, the new purchases are small, especially compared to the 80-trillion yen asset-purchase program. Kuroda was also quick to downplay the announcement, saying that Thursday's action didn't represent additional easing but rather an attempt to lower the yield curve and adjust policy. More specifically he said, "I'd like you to understand that we have taken those measures so we will be able to quickly adjust policy if we ever reach a conclusion that [further] action is needed to achieve the price-stability target at an early time."
Some traders argue that the BoJ's moves diminish the possibility of further QE later. But if Japan's economy continues at its current pace and oil prices remain low -- dashing hopes of a rebound in inflation -- more QE will remain on the table. In fact, Kuroda specifically said that the changes will enable them to adjust policy quickly if more action is needed. Considering that the market had anticipated no changes by the central bank, announcing an accelerated program -- as marginal as it may be -- 2 days after the Federal Reserve raised interest rates is positive for USD/JPY because it highlights the divergence between U.S. and Japanese monetary policies. We suspect that these steps will spark even more adjustments by policymakers around the world, particularly in emerging-market nations.
Meanwhile, with only 2 weeks to go before the end of the year we can safely say that 2015 has been a banner year for the U.S. dollar. It wasn't always easy being long dollars but the Federal Reserve breathed new life into the greenback this past week and now we look forward to further gains in 2016. Considering that next week is traditionally one of the quietest periods in the foreign-exchange market with average daily ranges in the EUR/USD and USD/JPY shrinking by 25% or more, it's the perfect time to revisit the consequences of a strong dollar -- some which are more obvious than others.
Consequences of a Strong Dollar:
- Less Exports, More Imports, Wider Trade Deficit
- Lower Inflation
- Lower Commodity Prices
- Weaker Earnings for US Companies with Significant Foreign Revenue
- Less Pressure on Major Central Banks like ECB to Ease
- More Pressure on Emerging Market Nations with Dollar Denominated Debt
- More M&A Transactions (which may not be a consequence)
- Weaker International Investment Returns
- More Pressure to Outsource
- Less Demand for Currency Alternatives such as Gold and Bitcoins
A strong dollar affects the U.S. markets and economy in a number of ways. In 2015, we've seen how trade and manufacturing activity can suffer from a strong currency and unfortunately troubles for this part of the economy will only exacerbate as the dollar rises in value. A strong dollar also affects inflation in two different ways -- it lowers the price of imported goods and drives down the value of commodities, which are priced in dollars. This will lower inflation affecting monetary policy around the world. A strong dollar has, and will continue, to erode corporate earnings. According to Factset data, 30% of U.S. based S&P 500 firms draw over 50% of their revenue from outside the U.S. and the value of this revenue will be less in U.S. dollar terms as the greenback rises. At the same time, a strong dollar increases the purchasing power of U.S. businesses, which should spark more M&A transactions in 2016. It also reduces international investment returns and increases the pressure on companies to outsource.
For foreign nations, a strong dollar can have different implications. The ECB will feel less pressure to ease because the weaker euro stimulates the economy, which in the long run will be positive for the Eurozone. Emerging-market countries, however, could be hit hard by a rising dollar because it increases the cost of servicing dollar-denominated debt. In fact low commodity prices, a rising dollar and Fed rate hikes pose a major risk for emerging-market nations next year. For currency alternatives like gold and Bitcoins, a strong dollar is bad news because it reduces the motivation for diversification.
Ultimately, a strong currency has more negative than positive implications for the greenback and could slow the process of Fed tightening.
Looking at the week ahead, it will be a shortened trading week, which means all of the data normally scheduled for release will be packed into 3 days. There are a handful of important U.S. economic reports including Q3 GDP revisions, personal income and spending. Economists are looking for softer numbers all around and as we have seen this week, even if they are right, it may not derail the dollar rally. The greenback could dip slightly on year-end flows but bargain hunters will sweep in quickly.
In Thursday's note we outlined all of the reasons why the EUR/USD could continue to fall. It has been a rough week for the single currency and with only German producer prices on the calendar, we don't expect a significant relief rally. Our target for the initial decline is 1.05 with a test of 1.03 also possible.
The rest of the major currencies were quiet. USD/CAD shot to 1.40 on the back of its CPI report. Consumer prices dropped 0.1% in November. Core prices fell 0.3%, which was not only significantly softer than the market expected but also the steepest decline since last December. The pressure is on for the Bank of Canada to cut interest rates in the coming year.