Economic pundits, almost without exception, are predicting a stronger dollar in 2015 – an expectation that is leading investors to place some very large bets. But that market strategy could turn out to be a very large mistake.
The consensus reflects the fact that the United States is currently the only major economy where growth prospects are improving. Most recently, the US Commerce Department revised upward its estimate of GDP growth for the third quarter of last year, to 5% – the highest rate in 11 years.
Moreover, the revision was based mainly on personal consumption and business investment – the most stable and persistent components of GDP. Consumer sentiment is at its highest level since 2007. Low oil prices, which reduce the cost of gas at the pump, provide an additional boost by giving US households more cash to spend at the mall. The unemployment rate is 5.6% and falling.
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All of this not only enhances confidence that strong US growth will persist; it also reinforces the belief that the US Federal Reserve will begin raising interest rates, conceivably as early as April. For investors, this makes buying dollars even more attractive.
The other major economies, by contrast, are stagnant, slowing, or both. Europe’s economy is dead in the water, and the dreaded specter of deflation is looming ever larger. Because policymakers are out of options, there remains little doubt that the European Central Bank will pursue quantitative easing, whether Germany likes it or not. European officials will welcome a weaker euro, which will improve competitiveness, at least modestly.
Meanwhile, in Asia, the Japanese economy’s sputtering indicators have spurred the Bank of Japan to increase its securities purchases, which likewise point to the prospect of a weaker yen. And unmistakable signs of slowing growth in China are leading investors to ask, for the first time in years, whether China’s government will seek to engineer a weakening of the renminbi’s dollar exchange rate.
Other emerging markets’ growth prospects are even worse – not least because of low commodity prices. As a result, these countries can expect lower capital inflows, again making for weak local currencies.
Such is the supposedly airtight case for a stronger dollar. How might it spring a leak?
A first reason to doubt projections of a stronger dollar is that none of the news on which they are based is really news. The expectation of relatively strong US growth is already being reflected in the markets, with the dollar up 9% in trade-weighted terms since mid-2014.
Given this, only a change in fundamentals – the US economy outperforms the consensus forecast and the Fed initiates monetary tightening earlier than anticipated, or other economies’ performance is even worse than expected – would cause the dollar to strengthen further. In short, with the market’s best guess already incorporated into the exchange rate, the dollar is as likely to fall as it is to rise.
The second risk is that, even based on current growth expectations, investors may have gotten ahead of themselves in anticipating monetary-policy tightening. The Fed will raise interest rates when it senses that the economy is nearing full capacity and that inflation – wage inflation, in particular – is accelerating.
Labor-force participation will be key to shaping this environment. As it stands, the low official unemployment rate can be explained partly by declining participation rates, especially among workers aged 25-54.
But there are now signs that the participation rate of these workers is stabilizing, and may even be set to rise. If it does, the unemployment rate may stop falling, and upward pressure on wages would be limited. The Fed would then delay tightening for longer than anticipated.
Last but not least, unexpected financial problems – which lower oil prices could catalyze – would interrupt US growth and discourage the Fed from tightening. After China and Japan, oil-exporting countries, including Russia, are the largest holders of US Treasury securities. If oil revenues fall further, they may be forced to sell those holdings, using the dollars to intervene in the foreign-exchange market and support their currencies or to bail out troubled banks, like Russia’s Trust Bank, the mid-size institution that the government rescued in December.
Such developments would cause US debt yields to spike, disrupting growth. The dollar would become weaker, leaving investors wrong-footed. The dislocations could be severe.
Currency forecasting is a mug’s game. Exchange-rate movements over horizons as long as a year do not function according to theoretical models. The behavior of currency markets has repeatedly confounded and even bankrupted sophisticated investors. With so much currently staked on the market moving in one direction, it is worth contemplating the consequences if this happens again in 2015.
Barry Eichengreen is a professor at the University of California, Berkeley, and the University of Cambridge. His latest book, Hall of Mirrors: The Great Depression, the Great Recession, and the Uses – and Misuses – of History, was just published by Oxford University Press.
Copyright: Project Syndicate, 2015.
www.project-syndicate.org
