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A Cautiously Optimistic Outlook for 2014 as CBs Enter Unchartered Territory

“Why do we suddenly all start making predictions for next year?” questions former FX Concepts chief strategist, Bob Savage. “In a market like foreign exchange we spend an inordinate amount of time worrying about what’s going to happen tomorrow or next week as opposed to what happens over the next year, but in December things slow down enough for people to sit back and identify some of the longer term trends that are really important.”

So what trends have FX market participants identified as being key ones for 2014?

This year’s outlooks have generally been rather timid in their claims, less from a lack of willingness to make predictions, but more because there remain so many variables at play in the markets right now that it is genuinely difficult to say what will happen in 2014.

The outlooks published this year have overall been cautiously optimistic for the FX markets and, while they predict small global growth, they realise that this growth is balanced on a knife point. The amount of “known unknowns” in the FX markets right now is significant.

Is the US economy capable of standing on it’s own two feet without QE? Is the UK’s recovery in H2 of this year a false dawn or a sign of things to come? What next for the still disparate economies of the Eurozone, an entity that appears to still struggle with fundamental structural problems? What impact will Abenomics continue to have next year? How will China’s slowdown impact the world?

These are all big questions with no clear answers. But despite this there do appear to be important consensus in the market around key trends to watch out for next year.

The outlooks for next year are almost all predicting the USD to perform better, although some do differ on to what extent.

There is concern about Europe as the euro continues to be strong despite some of the poor economic performances of its constituent members.

Trading in emerging markets FX is no longer seen as a panacea for the difficulties in the more developed markets.

But the underlying theme behind nearly every prediction being made for next year is the continued intervention of central banks in the economy and its subsequent impact on the FX markets.

Bullish on USD

Bank of America Merrill Lynch (BAML) is bullish regarding the USD, arguing that “The US story is not just about a simple cyclical recovery, but one of multiyear structural improvement”.

David Woo, head of global rates and currencies research at BoA, argues that the US economy is probably the most improved economy in the world this year and that it is actually “in its best position in 20 years.”

“The US will be the biggest driver of global markets in 2014, as it moves further ahead of other economies in the global business cycle. The strength of the US economy will drive the dollar, US interest rates and US interest rates volatility upwards, setting the general direction for the rest of the global rates and currencies market,” he says.

George Dowd, head of Chicago foreign exchange for Newedge, holds a similar view. He suggests the US dollar is likely entering a long-term bull market, with the primary driver being the now divergent monetary policy stances of the world's major central banks.

“The strength of the USD will be a main theme for 2014, though its strength compared to the other major currencies will vary with intensity based mostly on domestic events in those nations. For example, the USD could move the most versus the EUR in the run up to the European Parliamentary elections, especially if there is a surge in support for far right nontraditional parties.” he adds.

Deutsche Bank has also made an ongoing bullish call on USD for 2014. Strategist George Saravelos argues that an important trend this year has been the pricing out of QE, with the US curve bear steepening to extremes and treasury  inflows suffering as a result. Next year though, he thinks that the focus will be in US short-end yields moving higher and bear flattening.

“Flattening has historically been exceptionally supportive for the broad USD, as more stable long-term yields support a return of fixed income inflows and the attractiveness of the dollar as a funding currency diminishes. Put in other words, we don't think the Fed hikes in 2014. But just as the market front-ran the end of QE this year even though it will happen in 2014, we think next year will all be about short-end re-pricing even if Fed rates don't go up until 2015,” he says.

The second reason why Deutsche Bank is bullish on USD is its positive outlook on growth and by extension US equity inflows.

“This year has stood out for record outflows from US equities. Americans have invested record amounts offshore and foreigners have refused to engage in the S&P 500 rally….with relative valuations still not looking stretched, the broad dollar cheap and investors underweight US equities, there is little reason why the US equity picture can't improve in 2014,” says Saravelos.

Europe Continues to Confound and Confuse

The strength of the euro has continued to confound many expectations, but the fact is that many of the nations in Europe can’t live with a currency valuation that high because it is hurting their export business.

Europe isn’t the only place looking to devalue its currency though, as BlackRock points out in its outlook piece.

“The Eurozone, Japan and emerging market are all trying to export their way out of trouble. Who is going to buy all this stuff? The US consumer? This is tough to imagine without a growth breakout….Our conclusion: the math does not work (not everybody’s currency can fall at once),”  it says.

The question of how to force down the value of the euro is also tricky one for the European Central Bank (ECB) given the vastly differing states of the economies in the euro and would be politically very contentious.

“The ECB is at the zero bound, they can go lower on interest rates but they probably won’t. There’s talk of negative deposit rates, but if things don’t go their way in 2014 they might need something more significant, they might need QE,” says David Gilmore, co-founder of Foreign Exchange Analytics.

“But what does QE in Europe look like? There’s no Eurobond,” he adds.

One possible solution posited by Gilmore is that the ECB could buy treasuries, sell euros, then buy USD and spend those dollars on treasuries. He claims that if the ECB did this it would be a “game changer”, but predicted that the chances of this happening, while statistically significant, were only between 5-10%.

To further add to this uncertainty Europe is due for another round of parliamentary elections next year, with more politically extreme groups expected to gain greater traction in those countries whose economies are continuing to underperform.

EM to Struggle Again in 2014?

“I think that the biggest difference next year will be the emerging markets. We’ve always relied on the emerging markets to help us get out of some of our economic problems. But they’ve been spinning their wheels and, to a certain extent, going backwards,” says Dean Popplewell, director of currency analysis and research at Oanda.

Savage agrees with this analysis. “One thing that we learnt in 2013 was that emerging markets are not risk free,” he says before adding that in 2009 and 2010 EM was an easy place for FX traders to invest in. “Back then it was simple: you just went after the highest yield, it really didn’t matter because they were all the same.”

But since then it’s become clear that the flow of money in these countries was very much connected to the monetary policy of the Federal Reserve, of Japan and, to a certain extent, of Europe.

When the Eurozone didn’t break up and it became clear that the currency would survive and when it became apparent the QE in the US wouldn’t be infinite the money flows from these places to the emerging markets slowed significantly. With QE being slowly tapered in the US and the euro looking more steady than a year previously EM could struggle again next year.

“With the emerging markets having a slower growth countries like Australia and Canada will suffer and we’re starting to see that as well in commodities pricing,” says Popplewell.

In this regard the slowdown in the growth of China is likely to prove significant.

Australia’s biggest trading partner is China, and a common consensus is that the Australian dollar is only going to go down. The New Zealand dollar tends to follow the Australian one and the Chilean peso, being heavily reliant on copper exports, is also expected to struggle if China’s infrastructure investment slows down.

Gilmore also highlights the Canadian dollar as a currency that could find 2014 a difficult year. “I think that Canada is set to struggle next year with its energy exports as the US is able to produce more of its own. It needs a new market and I’m not sure that it’s well positioned right now,” he says.

Growth in emerging markets has slowed to 4.5% this year, the lowest since 2009, the IMF estimates. The recycling of current account surpluses through foreign exchange reserves is slowing, too.

BlackRock notes “that this is bad news for struggling advanced economies and financial markets addicted to monetary stimulus. What about the emerging word itself? EM has become a dirty word among investors of late”.

A strong US dollar hurts countries dependent on foreign funding. And propping up local currencies by selling dollars effectively tightens domestic liquidity.

Any discussion of what the FX markets will look like next year is, of course, dominated by how central banks intervene in the market.

Central Bank Policies Will Continue to Diverge

Popplewell anticipates that what he calls the “war of words” from central banks will continue for at least the first six months of next year as they all continue to covertly depreciate their currency.

He says that this is the same theme that he predicted for 2013 but that central banks have not moved on because the mass of liquidity that’s been injected into the financial system has failed to effectively filter through into the real economy.

“The biggest concern out there amongst the central banks is that this is unknown territory for them, and there is also the diversity question of different central banks reaching for different solutions.

“I think that they’re running out of options and it’s now there’s a race with the central banks to come up with something innovative. For the ECB it’s tentatively talking about negative rates, for the Fed it’s about convincing the market that they’re going to take some of the liquidity out but that rates are going to remain low,” he says.

The common consensus amongst the 2014 outlooks was overwhelmingly that in the longer-term it will be impossible for the Fed to continue tapering and keep interest rates low.

“Should we worry about the Fed’s (gentle) QE exit? It is not going to be a walk in the park, as some policymakers would like to think. We see it more as a triathlon in twilight. A healthy dose of humility is on order. The absence of a price-insensitive buyer will be felt. Policy words (forward guidance) replacing policy deeds (bond buying) equals a pick-up in rates and currency volatility,” says BlackRock in its outlook.

Savage argues the divergence in central bank monetary policy will be one of the key themes for next year.

“Since 2008 the world has had to act in a very co-ordinated way,” he says, “And for the first time this year we began to see that the “one size fits all” approach doesn’t resonate anymore.”

Savage adds that now it is clear that different countries need to pursue very different monetary policies. The Bank of Japan may need to continue growing its balance sheet, Europe may need to provide more bailout money, while the Bank Of England may tighten its monetary policy.

“We’re now seeing really divergent policies that aren’t just differences of opinion about how far one should go in terms of easing. And it’s not just in the developed world, but also in the emerging markets that we’re seeing this,” he observes, highlighting Indonesia and South Korea as two examples of this. Indonesia has a very weak currency that is close to experience some serious depreciation, there is capital outflow, currency account deficit all of which creates a spiral that could drive inflation.

In contrast Savage says that Korea became like a reserve “safety valve” for the troubles of places like Malaysia and Indonesia. If the yen continues to weaken and Indonesia’s problems persist then he argues that Korea might have to cut rates.

The multiplicity of different central bank’s approaches to managing their respective economies adds to the difficulty in making predictions for next year. This is in many ways unchartered territory and it remains unclear how these various policies will interact with one another and what their lasting impacts will be.

Overall, the 2014 outlook appears to be one of very cautious optimism that is further tempered by understanding that there are a number of variables in the markets that could set back next year’s predicted growth.

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