What is the currency in the business.

Currency

A rising U.S. dollar should be the financial market trend setter
of 2015. This means a de-facto tightening of global financial
conditions because the greenback is still the world’s premier
funding currency. More than 80% of international trade
finance is settled in U.S. dollars, according to the Society for
Worldwide Interbank Financial Telecommunication (SWIFT).
The second half of 2014 gave a possible glimpse of the future.
Small-cap equities and high yield bonds started to fall just as
the U.S. dollar took off. Large-cap equities stumbled, but
recouped all of their losses—and more.The impact of U.S. dollar swings on equities is nuanced.
Globalization means companies often rely on foreign markets
for a large chunk of their sales. European and EM companies
with U.S. sales could benefit from a strong U.S. dollar. European
equities generally stand to gain: Large caps collect about half
of their sales outside the region and small caps a third.} S lowing supply growth: The U.S. current account deficit is
shrinking largely thanks to rising energy production at home
(less need to import oil). See the chart above. The U.S. is
set to overtake Saudi Arabia as the world’s top oil producer
by 2015—and achieve self-sufficiency in energy within two
decades, the International Energy Agency predicts. The end
of QE also cuts the supply of dollars to the world to the tune
of $750 billion a year (the average annual amount the Fed
has bought since 2009).
} More demand: The Fed is set to raise interest rates in 2015—
whereas the BoJ has ramped up its monetary stimulus and
the ECB inches toward full-fledged QE. Policy divergence
means more dispersion (and opportunities) in currencies. An
increasing rate differential will likely keep demand for U.S.
dollar assets strong. The U.S. economy boasts advantages
over other developed economies (particularly Europe) in the
long run, including an entrepreneurial and flexible labor
force, leading research institutions and plentiful energy.
The bullish dollar view is reflected in futures markets positioning.
Trades against the euro look especially crowded, with short
positioning almost three standard deviations from the mean.

EM EMERGENCY?

EM countries typically bear the brunt of a stronger U.S.
dollar as funding sources dry up. Subsequent buying of local
currencies to prevent them from sliding effectively tightens
domestic financial conditions, we find.

Rising issuance of U.S. dollar corporate debt has created
pockets of vulnerability. Yet EM local currency issuance is rising,
reducing overall exposure to foreign exchange mismatches.
Another positive: International investment positions (the
difference between external financial assets and liabilities)
are pretty strong (page 19). Most governments are now net
creditors. (Warning: Companies often are debtors.)
EM countries will likely compete for liquidity by raising rates.
This will cause slowdowns and currency gyrations. Plus, shortterm
asset price movements are often about flows and investor
sentiment—which both can turn on a rupee. The good news:
EM currencies and equities were relatively cheap when the U.S.
dollar started its rise. A lot of adjustment has already happened.
A rising U.S. dollar also creates challenges for EM currencies
linked to the greenback. The big question: Will China devalue?
The Chinese Renminbi (RMB) has appreciated sharply against
the yen and euro, and China’s current account is about balanced.
This makes it tough to imagine the RMB appreciating further
against the U.S. dollar. Devaluation has pros (loosening financial
conditions to offset a property slowdown and making exports
more competitive) and cons (volatility and risk of deposit flight).

JOURNEY BEATS DESTINATION

Is the bullish view on the U.S. dollar already priced in? And is
further strength in the currency really a sure thing? We spent
some time debating this. Highlights:
} Forecasting currency movements has created many orphans.
Over the long run (five years or more), currencies track
fundamentals such as interest rate differentials. Valuation
often does not work in the short or medium term.
} Getting the direction right is one thing; getting the timing
right is another. Appreciation cycles in the trade-weighted
U.S. dollar typically last six to seven years. See the chart on
the right. Expect air pockets along the way. The journey is
more important than the destination. For example, the dollar
may fall for a year, but rally over five years (requiring patience).
} D ifferent paths to a stronger U.S. dollar could have different
portfolio implications. The benign version: Stronger U.S.
growth and rising rates lift the currency. A malign path:
A global growth slowdown triggers safe-haven buying.
Bottom line: Be humble about forecasting the U.S. dollar.

WHY WE COULD BE WRONG

The U.S. dollar’s rise has been muted compared with huge
rallies seen in the early 1980s and late 1990s, especially
given the wealth of intellectually tantalizing arguments for
appreciation. See the chart below.

There are three possible explanations for this:
1. We are underestimating markets’ Pavlovian tendencies.
Investors these days are conditioned to wait for monetary
policy to dictate market moves. Markets are standing by
until the Fed says: “Go!” Result: The U.S. dollar will only take
off when Fed Chair Janet Yellen fires off her first rate hike.
2. The monetary policy divergence story is wrong. Most of
us believe the U.S. economy should power ahead in 2015
(page 14), but some see a chance of growth disappointing
(it has happened before). In that case, the Fed could delay
its first rate hike to 2016. An even worse scenario for
dollar bulls: U.S. economic momentum stalls, leading to
expectations for a fourth round of QE. Or try this scenario
across the Atlantic: The eurozone’s economy performs
slightly better than expected (from a very low base), giving
air cover for the ECB to hold back from further (controversial)
monetary easing.

3. The arguments for a stronger dollar could be too good to be
true. Whenever a consensus is so unanimous, our gut tells
us it is wrong. Stretched positioning means even a mild
disappointment to dollar bulls could prompt a sell-off in
the currency. This would be a double whammy for those
expecting a stronger U.S. dollar versus the euro, but a boon
for EM assets and commodities.