By far the most consensual view today is that monetary policies, at least among major central banks, are headed in opposite directions. The Federal Reserve is tightening while both the ECB and BOJ are trying to double-down on quantitative easing (QE). Even the PBOC is perceived in some circles as a potential candidate for the dubious honour of embracing unconventional policies. The upshot of this supposed divergence is a disturbingly universal view, constantly repeated in the media, that the US dollar will strengthen further in 2016 taking dollar-denominated assets along for the ride. Unfortunately, the cozy comfort of this consensus thinking is an illusion that can lead to poor strategic thinking. A better framework would begin with the mix of policies, both monetary and fiscal settings, which are moving in the direction of convergence rather than divergence. Namely, central banks are gravitating toward a real policy rate of zero and most governments belatedly are shifting toward fiscal stimulus. This broad convergence in economic policies leads to some surprising macro implications, most notably less currency volatility and more economic growth. Even a weak US dollar is a possibility as is a minor recovery in Europe. In short, do not be distracted by conventional presumptions about the Fed’s tightening cycle and interest rates. The ultimate bogeyman of this investment cycle will be credit quality and the warning sign will be when banks tighten lending standards.
The Tenuous Link between the Fed and the Dollar
When central banks are out of sync, especially with the Federal Reserve, currencies do tend to revalue, usually in favour of the country offering higher real interest rates. The reason, of course, is that the differential in interest rates is an irresistible lure for the legions of carry traders, from banks to hedge funds, in the fluid world of globalised capital markets. There are caveats to this sacred tenet, however. First, the interest rate differential must be sufficiently large to offer out-sized returns. Small differentials do not have enough juice, even with the help of leverage. Second, asynchronous policies must be perceived as long-lasting. A short horizon doesn’t work. So whatever forces are believed to be causing the divergence in monetary policies must persist even as the favoured currency appreciates...