Fundamental Patterns Favor Additional Upside Momentum to the US Dollar Through Year-End

The Swiss franc, US dollar and British pound rank highest in performance among developed market currencies thus far this year in effective inflation-adjusted, trade-weighted terms by virtue of their comparatively attractive projected economic conditions as well as their safe haven appeal amid persistent Russian saber-rattling, Western European economic uncertainty and continued Greek financial indecision.  Anticipated trends among major currencies in the global foreign exchange market should proceed to move decidedly to the advantage of the US unit at the expense of the euro and UK pound in the months immediately ahead.

Even though the US economic recovery has suffered setbacks of late on the consumption and production fronts, Global Markets Intelligence (GMI) believes American aggregate demand will regain its stride and resume its gradual advance during the course of the year.  The Federal Reserve (Fed), in announcing yesterday that any forthcoming rate-tightening decision is now dependent on the trajectory of US economic activity (presumably, referring to underlying inflation or labor costs), hinted it may not rein in credit in the coming months in light of the fact it downgraded its expectations for domestic inflation.  Investors in the Fed fund futures market may still be erring in the direction a mid-year rate hike, but our interpretation of yesterday’s FOMC minutes and press conference convinces us a rate hike might not take place until the final quarter of 2015 or perhaps early 2016.

Irrespective of the timing of the Fed’s decision to tighten credit anew, fundamental patterns should pave the way for a relatively stronger US currency in the period ahead.  Comparatively low or maybe negative consumer inflation forecasts of the US, Eurozone, UK, Japan and Switzerland will confer little or no benefit on any of their currencies given the spirited efforts of their corresponding central banks to defend their economies against deflationary headwinds threatening to undermine the recoveries of each country.

Consequently, short-term interest rates are not expected to endow a significant advantage to any of the major currencies, other than sterling and the US dollar.  Even so, carry trades still favor shorting the US dollar in favor of a long position in its Taiwanese counterpart because of the upward tendency in short-term interest rates in many, if not most, Asian economies.  Fractional yields in excess of zero percent on front-end Japanese government issuance impart little, if any, strength to the yen.

Expected patterns in macroeconomic activity should aid the US and UK currencies to the disadvantage of their euro bloc, Japanese and Swiss rivals.  Obstinately strong refuge demand for the Swiss franc will continue to hamper growth of the nation’s exports as anticipated further appreciation against the euro proceeds to erode the competitive position of Swiss goods and services by lifting their cost in relation to those of the European Monetary Union (EMU) and Switzerland’s other export markets globally.  A projected modest uptick in Japan’s pace of economic expansion is not expected to provide much support for the yen going forward.

Meanwhile, the economies of Britain and the US appear on course to expand firmly again this year and next.  Projected growth rates of 3.0 and 2.6 percent, respectively, should further enhance the appeal of both the pound and dollar from an investment standpoint in spite of the fact that short-term interest rates may remain low for a prolonged period of time in both countries.

Short-run forecasts of international balance of payments would seem to depict a markedly different trend in the foreign exchange markets were it not for the fact that they exert more influence on currency patterns in the long- than in the short- or intermediate term.  Generally, economies with relatively high interest rates and fast economic growth rates (such as, in this present case, the UK and US) likely entail current account shortfalls depending on the sources of real GDP growth.  Bloomberg consensus expectations for 2015 and 2016 display just such a trend.  Nevertheless, we are of the opinion that projections of adverse external payments patterns will have little impact on the overall course of currency trends in the coming two years.

Near-term political events may prove especially volatile for the euro and sterling.  Departmental elections in France this Sunday (March 22) will probably witness another big victory for the far-right National Front party, according to the latest public opinion polls.   Yet, the center-right Union for a Popular Movement (UMP) – under the leadership of former President Nicholas Sarkozy, stands the most to gain at the expense of the ruling Socialist party on account of the latter’s record-low popularity in the eyes of the electorate.  Nonetheless, a significant turnout in support of the National Front could set off another round of capital flight, thereby intensifying downward pressure on the euro vis-à-vis the US dollar as well as on its crosses versus the franc and the pound.

May 7th parliamentary balloting in Great Britain could prove volatile to either the upside or downside for sterling contingent upon the outcome of the election.  If the incumbent Conservative party under the savvy auspices of Prime Minister David Cameron and Chancellor of the Exchequer George Osborne were to win an outright majority of seats in the House of Commons, investors should expect the pound to soar against the euro and possibly the dollar.

Even if the Tories were to capture only a plurality of seats in the lower house and its junior coalition partner, the Liberal-Democratic party, were to place second or third in the race, an anticipated alliance of the two parties would likely give rise to robust bout of sterling appreciation versus the US unit and on its cross against the euro.  An outcome in which the Labor party wins a plurality, or perhaps a widely unexpected slender majority, should the send the pound into a tailspin against both the US and EMU currencies.  A bleaker scenario might involve a deeply divided electorate splintering even further and elevating the profile of the UK Independence party in the lower house of parliament.  Needless to say, such an event would cause sterling to sell off sharply.

GMI believes British voters will reward the Conservatives with a slightly bigger plurality that the party received in the 2010 contest, requiring Cameron to negotiate another coalition regime with Nick Clegg, the leader of the Liberal Democrats – which, as a result, would keep the pound stable.

In summary, investors should stay long the US dollar and Swiss franc vis-à-vis the euro for both fundamental and political reasons in addition to potential event risk in the eventuality that Greece decides to exit the EMU and issue drachmas.  Hedging sterling exposures appears wholly justifiable in the event the UK electorate rejects the Tories in favor of the opposition Labor party.  Although the Japanese stock market ranks third highest with respect to performance so far this year, the macro-economy needs to demonstrate sustainable, uninterrupted growth and a rising cost of living before we would recommend long positions in the Japanese yen against any of the other major global currencies.

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