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2014: Year of the Strong Dollar?

I found these comments from BlackRock pretty interesting with regards to the US Dollar’s potential performance in 2014:

1.   The US economy is improving. As I discussed in a recent post, the economy is firming, and it’s improving at a pace faster than most other developed countries. For 2014 I would expect U.S. growth of 2.5% to 2.75% versus less than 2% for Japan and as little as 1% for Europe.

2.   The Fed will be pulling back at a time when many other central banks will need to maintain an ultra-loose monetary policy. By the end of the year, the Fed is likely to have exited its quantitative easing program. In contrast, most other developed market central banks – with the possible exception of the Bank of England – are likely to remain in an easing mode. In particular, the Bank of Japan will continue with its very aggressive asset purchase program for another couple of years. This should lead to a weaker yen.

3.Valuation. Today, based on purchasing power parity, many of the key developed market currencies look expensive relative to the dollar. Based on the Purchasing Power Parity Index compiled by the OECD, the Swiss Franc and the Australian dollar look to be 25% or more overvalued against the dollar, while the Canadian Dollar and British Pound look 10% to 15% overvalued, and the Euro appears roughly 5% above where fair value would suggest it should be. Of the major currencies, the yen looks the cheapest relative to the dollar, but as stated above, it’s still likely to weaken on the back of aggressive easing by the Bank of Japan.

The one that really jumps out at me is Fed policy.  Europe, Japan and China look pretty weak on a relative basis.  And there are certainly no signs of central bank tightening in any of those nations.  And since FX is ultimately a relative value game, you have to consider how interest rates and central bank policy will come into play.  I think BlackRock probably has this one right.  If you had to single out a strong currency in 2014 the USD looks like the one to pick.

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