Currency Forecast: Are People Regaining Faith In The Dollar?

Includes: FXY, UUP
by: I Know First Research

The values of fiat currencies are hard to measure because they are assessed mainly upon confidence in the government and expectations from the central bank. Though there is some room to analyze currencies based on fundamental data, such as inflation rates, retail sales, and trade balances, often speculation and fear are the most significant factors. Kathy Lien of Currency Trader magazine wrote, "more than 80 percent of currency trading volume is speculative in nature and, as a result, the market frequently overshoots and then corrects."

Because currency trading is so driven by speculation, often economic misconceptions heavily influence currency prices, defying fundamental analysis. In this article I will discuss two major misconceptions that have critically influenced the value of the US dollar (NYSEARCA:UUP) in the past few years: the fear of runaway inflation and the fear of a US bond bubble. I will proceed to explain how these fears developed in America, how they have so far proved to be untrue, how similar fears may have an analogous impact on Japan, and how currency investors can profit from the dollar's inevitable correction.

Fear of Inflation

During the financial crisis of 2008-9, the US Federal Reserve began a policy of expansionary monetary policy, to keep interest rates low and stimulate non-governmental consumption and investment. To achieve its goal of a looser monetary policy the Fed embarked on three rounds of quantitative easing, a means of expanding the monetary base (Chart 1).

Though perhaps irrationally, many Americans feared that such policies were essentially channels for the Fed to print money, thus monetizing the national debt and leading to soaring inflation. Many of these skeptics have poured their investments into gold and other commodities because they feared that dollar would steadily lose its value as it became more abundant. However, the American inflation rate has stayed comfortably below the Fed's target, the Fed has made it clear that it will reverse this trend once the economy improves, and the US Congress is in fact trying to cut its budget rather than expand it.

Though many have remained skeptical throughout the financial crisis, now that the economy is starting to improve and the Fed is expressing that it will live up to its promises to reverse its expansionary policies soon, their fear of runaway inflation is beginning to subside. Marshall Gittler of CNBC notes that those who had originally invested in gold as a hedge against the dollar are beginning to invest in more productive assets.

Fear of a Bond Bubble

Though quantitative easing hasn't caused runaway inflation, many experts have been cautioning that it has paved the way for a bond bubble, as the Fed has artificially been boosting demand for such assets. Professor Moorad Choudhry faults the Fed for artificially boosting the stock and bond markets, creating an environment where people believe "they can't lose: if markets go up, they will win; and if markets go down, the central bank will throw in more cheap money and more asset purchases."

Though, these experts correctly attribute the historically low bond yields (Chart 2) to the Fed's actions, economist Paul Krugman argues that they fail to give credit to the Fed's ability to control such sentiments; the Fed will not allow a calamitous bubble to be created that will devastate the economy. Rather, it will act super-rationally and properly manage investors' expectations by explaining their long-term plans and goals.

Fed Chairman Ben Bernanke has already stated that the Fed will keep interest rates low until unemployment decreases further; and with incredibly low inflation rates (Chart 3), he has no inflationary pressure to mitigate his policies. Because Bernanke understands that a bond bubble can potentially be created if the Fed manages its loose monetary policies poorly, he began working on an exit strategy as early as 2008 when he began paying banks interest on their reserves.

In February 2012 he explained to Congress that he was aware of the dangers of drastically expanding the money supply, and therefore suggested a few measures he planned to take to reverse such policies. Therefore, when he recently announced that he was going to tone back his aggressive policies, even though the markets expressed disappointment, they were expecting such an announcement and therefore didn't lead to panic.

So What Does This Mean For the Dollar?

Because there are so many investors in the stock market who irrationally believe that quantitative easing will inevitably lead to uncontrollable inflation and a huge bond bubble, the stock and bond markets have been tremendously influenced by the public's unfounded beliefs and expectations, rather than by traditional market logic. When more people are making financial decisions based on untrue information, the stock markets behave more like a random walk than a mean reverting asset; in other words there is about a 50/50 percent chance that the stock market will go up or down, and is therefore much more difficult to predict.

Perhaps now that people are regaining faith in the Fed and are acknowledging that runaway inflation isn't likely, they will pay more attention to the American economy's strong performance; recently the Standard & Poor's rating agency upgraded America's economic outlook, citing the Fed's policies as the main driver of growth. Additionally, despite government spending cuts and tax increases, the US economy continues to grow at a steady pace of approximately 2%.

Since currencies are mainly driven by expectations and speculation, if investors become convinced of the positive trajectory of the US economy and acknowledge that the Fed's loose monetary policy will end once the economy significant improves, then they will develop a positive general outlook for the US dollar. Once the misconceptions and irrational fears are discarded, people will realize the dollar's true value.

How Does the Dollar Compare to the Yen?

The Japanese central bank is following the Fed's lead by adopting its own quantitative easing policy, and the yen FXY has since fallen against the dollar. The Japanese economy is also growing at a similar rate to that of the US economy. As the US is ending its expansionary policy, many are beginning to regain faith in the dollar and as Japan begins its expansionary policy many are losing faith in the yen. Even if fundamentally adopting quantitative easing doesn't lead to inflation, it has created the expectation that the yen will decrease in value. Perhaps more importantly, the Japanese Prime Minister, Shinzo Abe stated that he wanted the yen to continue to depreciate. If the general expectation is the yen will fall further, then it makes sense that it will further depreciate against the US dollar which is showing few signs of weakness, real or imagined.

Conclusion: Is the Dollar a Buy?

People are finally beginning to acknowledge that America's economy is growing steadily and that the Fed's monetary policies aren't leading to high inflation. Though Europe's fundamental weakness has already been factored into the euro's price, I believe that the yen still has further to fall. The Japanese government explicitly said that it wants to devalue its currency and it has made it clear that it actually plans to encourage inflation. I Know First cofounder Dr. Roitman explained that currencies tend to move in long-term trends and as the US dollar has steadily lost ground against the yen for about four years since the start of American quantitative easing (Chart 4), it would appear that the dollar's relatively recent upward trend will continue. Since the currency markets are heavily influenced by misconceptions about central bank policies and are consequently highly prone to overshooting reasonable exchange rates, I believe that the US dollar still has more time and room to grow against the Japanese yen.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Business relationship disclosure: I Know First Research is the analytic branch of I Know First, a financial startup company that specializes in quantitatively predicting the stock market. This article was written by Ethan Fried (Harvard College '16) one of our interns. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.