(1) The US economy, although growing slowly, was still producing stronger growth than any other developed economy,
(2) This strength led to suggestions by the Fed that interest rates would likely rise on 4 occasions this year to head off any inflationary pressures caused by rising employment and such steady growth,
(3) The other developed economies, notably the Eurozone and Japan, were being led by central bank policies that seemed committed to maintaining a low interest rate environment almost indefinitely, with the result that the interest rate differentials between the USD on one side, and the Yen and Euro on the other would likely only widen, thus making the USD more attractive on a relative basis. For one currency to be strong the obvious point is that its counterpart must be correspondingly weak.
As we go into May, the narrative seems rather different (to put it mildly) as the Fed in the US has postponed its planned rate increases in the face of sluggish global growth, and as the effectiveness of central bank action in the Eurozone and Japan seems questionable, if not totally ineffective.
This was brought into stark relief at the end of last week when the Bank of Japan (BoJ), opted to do.... precisely nothing, despite a nearly unanimous consensus expectation ahead of its April meeting that the moribund state of the Japanese economy would force it to take extreme measures to devalue the Yen. Reflecting this view, last month we actually said that in April:
"the Japanese market could be boosted by the Abe government’s moves to front-load fiscal stimulus in to H1CY16. A majority of economists expect BOJ QE action next month, and we continue to feel that this will be reflected in resumed Yen weakness",
but what ACTUALLY happened was
"For the second time in three months the BoJ stunned financial markets last week, this time for holding monetary policy settings steady when most were expecting either an increase in asset purchases or a further reduction in interest rates, or both.
The fallout for the decision was instant, and epic.
The Japanese yen screeched higher, recording its largest one-day percentage gain in more than five years, while the Nikkei 225 — Japan’s benchmark stock market index — tumbled more than 8% in just over one session of trade.
For other central banks, it served as a timely reminder as to just how savage markets can react when lofty expectations aren’t met by policymakers" (Business Insider May 3rd 2016).
As Goldman Sachs - whose expectations of BoJ action were every bit as lofty as everyone else's - noted in a research piece:
“Unconventional easing is above all an expectations game, where it is necessary to shock markets again and again, until they have no reason to question a central bank’s commitment to its inflation target”
Last week, however, the BoJ chose to shock markets by doing nothing.
The trouble is that the BoJ and possibly other central banks are now running headlong into market doubters who question their ability to get inflation moving, a doubt which will only be exacerbated by what looks to be a disconnect between words and actual deeds. This means that the size of any future "shock" they will need to deliver in order to convince markets of their seriousness will have to get progressively bigger too.
Good luck with that. Since the beginning of this year the USD index has declined by nearly 6%, and against the Yen by over 13%. This is good news if you are a USD based investor, but not if you are not: any gains that the latter might have seen in underlying investments will have been eliminated by the depreciation of the USD.
A Yen rate at 106 or so means that many Nikkei constituents will be posting earnings declines this year. At the start of 2016 the forecast was for earnings growth of between 10% and 20%, based on a year end Yen forecast of about 120. Although that now looks a challenging target to meet, since "Abenomics" appears to have no plan 'B', it would seem logical that both the Japanese government and the BoJ will have no choice but to double down further with an expansion of the negative interest rate regime savers in Japan so dislike, whilst pushing harder for more corporate reform.
At the same time, the first of the delayed US rate increases seem likely to come through in Q3 2016 which should help increase demand for the USD and a sell down in the JPY and EUR.
That's the theory anyway...
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