OCEAN CITY — One exchange-traded fund (ETF) tracking a broad index of Japanese equities provided a return of 42% last year while another one doing the same thing delivered 26%. The critical difference was that the first ETF hedged its foreign currency exposure against the falling Japanese yen while the second one did not. With variations in returns like these and a growing number of vehicles that hedge these exposures, it’s timely to consider the outlook for currency moves this year.
We started 2014 as U.S. dollar bulls, expecting the greenback to appreciate during the year against currencies of major trading partners, including the euro and yen. We are still waiting patiently for that to happen. The U.S. Dollar Index (DXY), which measures the U.S. dollar against six major currencies (euro, yen, pound, Canadian dollar, Swedish krona and Swiss franc), has been largely flat year-to-date. In fact, it has settled into a relatively tight trading range since last September. As a result, volatility across many of the major currency markets has continued to decline.
We continue to believe that the U.S. dollar should appreciate through 2014. Our patience could be tested further in the second quarter as currency markets look for guidance, but we still believe this patience will be rewarded.
The U.S. economy is likely to prove the strongest within the developed world as growth accelerates in the coming quarters.
BofAML Global Research predicts the U.S. economy will pick up from lackluster growth of 1.7% in the first quarter of 2014 to more than 3% in each of the next three quarters — a higher rate than the majority of the developed economies.
Consistent with this outlook, the U.S. Federal Reserve (Fed) appears closer to raising interest rates than either the Bank of Japan or the European Central Bank, which are more biased toward easing monetary policy. The Fed is not
likely to raise interest rates before 2015, but the market can be expected to discount the possibility sooner, resulting in higher Treasury yields even at shorter maturities. Remembering that currencies, unlike other assets, are relative in nature, strengthening or weakening against one another, it is important to consider the actions of the Fed or the progression of U.S. Treasury yields in relation to other countries rather than in isolation. Our view is that U.S. Treasury yields will rise with respect to their counterparts in other developed markets, supporting a stronger dollar.
We believe the prospect of additional monetary easing by the ECB has increased in recent weeks. Inflation in the Eurozone continues to come in well below the ECB’s target and private sector credit conditions remain unfavorable to smaller companies, which weighs on employment and inflation. BofAML Global Research European Economics team noted that at the ECB’s April monetary policy meeting, the Governing Council was unanimously open to adopting unconventional policies, although it did not specify thresholds for taking action. BofAML Global Research believes the ECB could adopt quantitative easing (QE) as early as the third quarter should inflation remain disappointingly low.
Crucially, policymakers have tied the risk of lower inflation (and in turn a greater likelihood of monetary action) to the prospect of a stronger euro. This, we believe, has stemmed the appreciation of the euro, which has risen from below 1.30 U.S. dollars/euro last summer to just below 1.40 currently.
In our opinion, the greater likelihood of monetary easing in the Eurozone combined with the expectation of monetary tightening in the U.S. should lead to relatively higher interest
rates in the U.S., and in turn a stronger U.S. dollar versus the euro through the remainder of 2014.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)