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US Dollar Will Benefit from Taper, Risk Trends and Growth in 2014

US Dollar Will Benefit from Taper, Risk Trends and Growth in 2014

John Kicklighter, Chief Strategist
US_Dollar_Will_Benefit_from_Taper_Risk_Trends_and_Growth_in_2014_body_usdollar.png, US Dollar Will Benefit from Taper, Risk Trends and Growth in 2014

Fundamental Forecast for US Dollar: Bullish

  • The dollar meandered through 2013 as persistent risk trends and stimulus defused the currency’s two most prominent catalysts
  • In 2014, the Fed’s shift towards Taper and the probability of a 15-25 percent S&P 500 decline find the dollar well positioned
  • Think the dollar is poised to rise or fall in 2014? Take a diversified position on the USD using our Mirror Trader currency basket

The 2013 trading year was a mixed one for the US dollar as the chase for yield and persistent stimulus push by the Federal Reserve curbed the support from the economy’s underlying strength. Looking ahead to the new year, though, the start of the Fed’s Taper regime and the high probability of a meaningful correction in capital markets (the S&P 500 acting as the symbolic risk figurehead) put the greenback in a position of steady strength with periods of intermittent rallies.

Before considering the more uncertain and market-moving scenarios for the dollar heading into 2014, it is important to appreciate the currency’s understated but steadfast performance this past year – derived from factors that are likely to persist moving forward. From the Dow Jones FXCM Dollar Index (ticker = USDollar), 2013 opened to quick gains and the index would not return to those lows after early January. This reflects a general strength against high yield (Australian and New Zealand dollars) and fellow safe havens (Japanese yen) alike. The dollar’s worst performance amongst the majors was suffered against the Euro – though that amounted to a relatively modest 3.6 percent decline.

This even performance is remarkable considering the S&P 500 set fresh record highs 41 times through 2013. Historically, the correlation between the benchmark equity index and currency is negative. This relationship derives from the dollar’s position as a safe haven, which is beneficial during periods of financial market uncertainty and detrimental during phases of strong growth. Yet, for much of the year, the correlation maintained an exceptional, positive connection – hitting extremes not seen since 2002.

Many believe that this change represents a fundamental separation for the benchmark currency from its past on the extreme end of the risk spectrum. The oscillation between fear and greed is eternal. And, while the dollar will eventually lose its billing the world’s premier currency for liquidity and reserve status; that change is much further into the future. In reality, the greenback has taped other aspects of its fundamental backdrop to maintain buoyancy. Though, should the onus of fear return, the dollar is likely to step back into its role.

Through the past year, the deepest correction from the S&P 500 was a mild 7.5 percent. In fact, since the recovery from the Great Financial Crisis began in the first quarter of 2009, there has only been one instance of a 20-plus percent correction for the capital market benchmark. Meanwhile, over that same period, the index has advanced over 170 percent peak-to-trough. The return of capital following a crisis, strong corporate profits and the return to growth have all contributed to some extent to this performance. That said, these are heights that arguably far-exceed the level of expansion and investment returns (yield) observed. Much of these ambitious positioning has been supplemented by record levels of leverage and a firm since of ‘moral hazard’ (the sense that an investor is taking no risk upon themselves under the belief that another player – central banks – will absolve it).

For 2014, the probability of at 15 to 20 percent correction is US equities is high. Any meaningful catalyst that erodes complacency and sows doubt can develop into a forcible deleveraging event. And, when the market is scrambling for safety, the dollar will benefit.

Establishing the spark for risk trends is nothing short of a practice in futility, but there are a few looming threats that can accomplish it. Perhaps the most prominent danger is the Federal Reserve’s turn in its policy bearings. Turning from the illusion of ever-expanding stimulus, the central bank started to wind down with its $10 billion Taper (to $75 billion in asset purchases a month) on December 18. The ramifications of this move have not been fully felt due to the holiday liquidity. Into the new year, investors will have to reassess their exposure against the backdrop of rising rates – and more costly leverage.

The increase in yields will tender another benefit for the dollar – a rising carry. While its yield is far from that of a true carry currency, it will see its cost unwind positions using the greenback as a funding currency. And, similar to what the pound enjoyed through the second half of 2013, the forward looking market will start to price in future rate cuts with the US well placed in the pack. - JK

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.