As frigid weather conditions keep much of the U.S. and Canada in an icy grip, investors will get to feel the heat of real market action by way of a busy trading week chock-full of economic data releases. Since the festive holidays, all asset classes have been playing make-believe, with liquidity remaining as the unknown variable.
2014 is expected to be a very different year for various central banks with the previously united stimulus front about to get a general makeover. Following the leader is not going to be a prerequisite anymore. The Federal Reserve is to get a new head and Janet Yellen will be remembered as the lady who began pulling back on the U.S.'s quantitative easing amid stronger domestic growth (in turn preserving outgoing Chairman Ben Bernanke's legacy). Across the Atlantic, Bank of England Governor, Mark Carney, will be doing his level best to try to cool the U.K.'s red-hot housing market, while his counterparts at the European Central Bank (ECB) and the Bank of Japan (BoJ) will be fighting fears of "deflation." As early as this week, ECB President Mario Draghi and company may put into motion various monetary actions or policies to stimulate price movement.
Quantitative Easing to Continue
To all foreign exchange (forex) watchers, it has become obvious that the "mostly synchronized stimulus that supported the world economy for the past six-years, " has many investors believing that the sign-posted trade for 2014 is a much stronger dollar, aided by higher long-term U.S. Treasury yields. Should the market now be expecting the end of easy money? Nope, not possible; the ECB and especially the BoJ will be most concerned about deflation applying a death grip on the European and Japanese economies. The priority again for most central banks will be keeping interest rates at or near record lows. For the past six months, the Fed has gone to great lengths to convince the market that tapering is not equal to a tighter monetary policy. Investors appear to have finally bought into this judging by the shape of the U.S. yield curve. The front of the curve remains relatively low (U.S. two-year yields +0.39%), while the tail continues to back up in an orderly fashion (U.S. 10-year yields +2.98%).
The central bank with the different monetary stance will be giving investors an opportunity and that's the best they can hope for early in 2014. For the past two-years, the various asset classes have been handcuffed by central bank actions, making it very difficult to find that utopian investment trade. In forex, both volume and volatility was dramatically curtailed by central bank interventions during the second half of 2013.
The varying central bank monetary themes for 2014 will provide investment opportunities, especially when policymakers get a stronger handle on how best to implement their own monetary policies. For the Fed, this week's U.S. jobs report will surely set the tone for the depth and breadth of the U.S. taper. With Bernanke's exit pending, it was easier to introduce a token taper last month and he managed to get the ball rolling, but how much momentum does the U.S. economy really have?
An economy that is gaining traction will eventually lead to higher borrowing costs via higher Treasury yields. This scenario goes a long way to support the mighty dollar throughout 2014. Last year, against its 10 largest trading partners, the greenback happened to rally +3.5%. The varying economic trajectories amongst the G-10 members should be capable of boosting the dollar’s value even higher. If central bankers don't handcuff the forex space as they have over the last 18-months, there is a distinct possibility that both volume and volatility may be capable of making a much-anticipated and welcome return.
In the U.S., stocks were the big winner in 2013. Despite starting out this year on the back foot -- Asia is currently leading the global equity market correction – stocks are very capable of having another stellar year in 2014. With major central banks beginning to set down on diverging paths in terms of monetary policy, consistent growth traction in the U.S. could lead to the greatest "gravitational pull" story for this year, providing even more support for the mighty buck.
Hot Chinese Economy Starts to Cool
Even China's growth story is beginning to change. The HSBC China services Purchasing Managers’ Index (PMI) data released last weekend managed to hold onto growth, but it was the lowest reading in nearly 32-months. Europe is not that different; this morning's peripheral Eurozone PMI services data continued its improving trend -- Ireland and Spain reported seven-year highs. However, the core again highlighted the uneven economic recovery for the region as a whole.
Little will discourage the Fed's current actions. Bernanke's second term ends in a matter of weeks and this week’s U.S. employment report will go a long way in helping to decide how much American policymakers will pare back the Fed’s monthly bond purchases – somewhere between $10-billion and $75-billion. The market believes that the Federal Open Market Committee (FOMC) will continue to taper over the next several meetings before ending the program 11-months from now. The Fed will act alone, and it will not be influenced from those outside its hallowed halls. The outsiders, the central banks of G-7 nations in particular, are concerned that higher rates in the U.S. will eventually drag their own domestic rates higher, threatening more-fragile expansions elsewhere. Analysts will tell you that this is a very likely scenario because of the "highly correlated" capital market system that democratic economies run.
The ECB has been proactive against weakening price pressures. Last November, European policymakers cut the benchmark rate to +0.25% "to shore up inflation now less than half its target of just below +2%." Other headline data helps to support this move. The Eurozone’s third-quarter gross domestic product fell -0.4%, while October's unemployment rate remains close to a record high (+12.1%). Reports like this certainly do not rule out further easing in the short term. There is a real possibility that the ECB may have to implement "negative" deposit rates or offer new long-term loans. Either course of action should put the 18-member single currency under pressure. December has been a horrid month for the weaker EUR short positions – they have mostly lost the battle, but not the war. Many have been squeezed out at most opportunities over the past few weeks, pressured even more so by lack of liquidity. However, this is a new week, a New Year, and soon it will be a deeper market with more investors.
The BoJ may be required to inject more fiscal stimulus, especially since Prime Minister Shinzo Abe's government will raise the sales tax to +8% from +5% in April to curb national debt. Consensus believes the Japanese government will be required to boost its asset purchases to achieve a +2% inflation target. Short-yen outright against the dollar was the patience trade for last year. Those positions will again dominate forex talk for the first half of 2014, with ¥110 being the medium-term target.
Britons Need Clear Guidance
Governor Carney is in a tough position. The BoE has already indicated that its benchmark rate will stay at +0.5% this year. However, relatively stronger data is pushing U.K. policymakers toward a stimulus exit. Just before Christmas, the BoE indicated that it would "dilute a credit-boosting program as housing prices, sales and mortgage demand all accelerate." It may be time for the BoE to scrap its forward-guidance methodology and tell everyone how long it intends to maintain the +0.5% cash rate. British policymakers have very much underestimated the economy's strength. The unemployment rate could hit +7% this year rather than in 2016 when first reported. Sterling seems to have found some support after dropping -250-points from its 2014 highs (1.6605). U.K. PMI data would suggest that the pound looks like a good bet at current levels.
Okay, the U.K. will stick, the ECB could ease and the BoJ may buy more assets, but who will be the first to tighten in 2014? The odds favor the Kiwis. Many expect the Reserve Bank of New Zealand to be the first to raise its benchmark rate this year, from +2.5%, "as accelerating economic growth and a housing boom stoke price pressures." No matter what, the risk of a premature withdrawal of support (BoJ in 2000, ECB in 2008 and 2011) will leave policymakers relying more on forward guidance this year. Being clear and precise with all policy messaging will avoid confusion. Telling the public how long to expect low rates helps investors to restrain market-borrowing costs, while promoting investment. It's not a new concept, but it’s a necessity. The FOMC has been successful in its messaging – "tapering isn’t the same as tightening monetary policy." The BoE should take note.
This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.
