2008 Price Action: It has been an exceptionally active year in the foreign exchange market as currency volatilities hit record highs. In the first half of the year, everyone was worried about how much further the dollar would fall but in the second half of the year the concern became how much further the dollar would rise. More specifically, after hitting a record low against the Euro in the second quarter, the US dollar surged to a 2 year high against the currency in the beginning of the fourth quarter. From trough to peak, the dollar index rose more than 23 percent in 2008.
3 Themes for 2009: The US economy and the dollar’s fate in the years ahead could be determined by what happens in 2009. We are focusing on 3 big themes that will impact the US dollar and each of these themes encompasses a lot.
1. U or L Shaped Recovery: The US is in recession and the slowdown is expected to deepen in 2009. Before a recovery is even possible, the economy has to work through more weakness and negative surprises. Non-farm payrolls declined by 533k in November, sending the unemployment rate to a 15 year high of 6.7 percent. With many US corporations forced to tighten their belts, the unemployment rate could rise as high as 8 percent. We expect this to happen because over the past 50 years on average, recessions have boosted the unemployment rate by 2.8 percent. When the current recession started in December, the unemployment rate was 5.0 percent. If you tack on 2.8 percent, that would drive the unemployment rate to at least 7.8 percent.
Therefore non-farm payrolls could double dip, just as it has in past recessions. In this case, we would expect a rebound followed by another sharp loss that rivals November’s job cuts. A rise in unemployment spreads into incomes, spending and then usually leads to more layoffs. We need to see this toxic cycle end before we can see a recovery. Consumer spending has already been very weak and the trade deficit is widening as the dollar strengthens. As the 2 primary inputs into GDP, we expect fourth quarter growth to be very weak. The strength of the US dollar in Q3 and for most of Q4 will also take a big bite out of corporate earnings, leading to disappointments for the stock market. This is why we expect more weakness in the US dollar and the US economy in the first quarter of 2009. However towards the middle of the second quarter, we may begin to see the US economy stabilize as it starts to reap the benefits of Quantitative Easing and President Barack Obama’s fiscal stimulus plan. New Administrations usually hit the ground running and as such we fully expect the rest of the TARP funds to be tapped shortly after his inauguration. The shape of the US recovery will have a big impact on the price action of the US dollar and the path to a stronger dollar will be through a weaker one.
The following chart illustrates the double-dip trend of non-farm payrolls during the 2001 recession.
2. Safety vs. Yield: The dollar’s rally in the second half of 2008 has been largely driven by risk aversion, deleveraging and repatriation. In other words, despite the next to nothing yield offered by dollar denominated investments, a flight safety into US dollars and government bonds has kept the US dollar from collapsing against currencies like the British pound, Canadian and Australian dollars. The concern for safety was so high that investors were willing to take negative yields just to park their money with the US government. A bubble is brewing in the Treasury market and any improvement in risk appetite will take the market’s focus away from safety and back to return on money at which time ultra low interest rates could become a detriment for the US dollar. The dollar’s performance against other currencies would be contingent upon growth in the rest of the world. For example, if the UK economy is in the process of recovering, demand for yield and the prospect of return could send the GBP/USD higher, but if the recession in the Eurozone deepens, then the Euro may no longer be the flavor of the month.
3. Compression in Interest Rates and Volatility: Volatility in the currency market hit a record high in 2008 but in 2009 we expect the volatility to compress as interest rates around the world converge. Much of the volatility this past year has been spurred by speculation about how much various central banks would cut interest rates. As they run out of room to ease, we may stop seeing monetary policy surprises which can eventually lead to stabilization for carry trades. Don’t expect this to happen in the first quarter however as many central banks are still expected to cut interest rates. The Fed’s rate cuts have long been a big driver of market volatility and now that risk is off the table. When the monetary and fiscal stimulus start to impact the US economy, the market may actually start talking about a rate hike in the US. Interest rates cannot remain at zero forever, especially if inflation starts creeping higher in the second half of the year.
Growth: Although we expect the US economy to start its slow recovery in the second half of 2009, GDP growth next year will still be negative. Retail sales and non-farm payrolls will be particularly ugly in the first quarter, but we are optimistic that monetary policy and fiscal stimulus will begin to help the economy. The record decline in mortgage rates should also help to stabilize the housing market in 2009. Something between a L and U shaped recovery is likely.
Inflation: Deflation is much more of a problem for the US economy than inflation. Oil prices are more than 75 percent off their highs. As a result, we have seen either flat or negative consumer price growth every month between August and November. The December numbers have yet to be release, but there is no reason to expect CPI to be positive. Since the beginning of the year annualized consumer price growth has fallen from 2.1 percent to 1.1 percent. The US economy has not officially hit deflation, but with commodity prices continuing to fall and consumer demand slumping, deflation will become a greater risk than inflation in the first half of 2009. However this may change in the second half as Quantitative Easing, fiscal stimulus and hopefully a weaker currency boosts inflation.
Monetary Policy: US interest rates have fallen 400bp from 4.25 percent to 0.25 percent in 2008. For most people, interest rates at 0.25 percent are as unattractive as zero interest rates. With US rates pretty much at zero, the Federal Reserve has informally adopted its own version of Quantitative Easing. Some people may even argue that the Fed has been pursuing this strategy for months now. In conjunction with the Treasury department, the Fed has doubled their balance sheet in the past 3 months to more than $2 trillion. They have done this by purchasing direct equity investments in banks, easing standards on commercial paper purchases, made efforts to relieve institutions of their toxic asset-backed securities and are now considering buying Treasury bonds and agency debt. By buying these assets, they are adding money into the financial system. Like the Yen, Quantitative Easing exposes the US dollar to significant downside risks because the Federal Reserve is basically printing money and using that money to flood the market with liquidity, eroding the value of the dollar in the process. However it is a step that the central bank needs to take to stabilize the US economy and to prevent a deflationary spiral. The central bank will not be worried about a weak currency and will in fact welcome one because they know that a weaker currency is like an interest rate cut in many ways because it helps to support and stimulate the economy.