2015 was certainly a year of commodity price volatility. We don’t need to post graphs or quote numbers to illustrate the extent of the fall in prices from steel and iron ore. Through base metals to energy we, and just about everyone else, have written extensively about the fall in prices in recent months.
But 2016 is unlikely to see falls of the same order as last year. Indeed, there has been something of a dead cat bounce in prices late last month. For a number of reasons aluminum, iron ore and oil prices have all seen an uptick although few are predicting this is the start of a rally. Most would hold it is simply a reaction to wider geopolitical developments and will, in time, be seen as volatility around a continued downward trend line.
2016, however, is seeing the first major divergence in interest and, hence, exchange rates since the financial crisis. The Federal Reserve‘s tepid rate increase last month has not, as often happened pre 2008, been mirrored by moves in Europe, Japan or the emerging economies.
Indeed, expansionary monetary policy is the order of the day in Europe and Japan where Quantitative Easing (QE) is likely to continue in 2016 and interest rates will remain near zero. A recent Economist article noted the gap between American and German bond yields that reflects this divergence in future interest rate expectations.
Late last year, five-year Treasury bonds yielded 1.785%; German bonds with the same maturity had a negative yield of 0.14%. That is the biggest gap since the creation of the euro. The same article went on to suggest currency risk could become a big source of turbulence in financial markets this year.
The volatility of the dollar versus the euro and yen, as measured by contracts traded on the Chicago Board Options Exchange, stayed below 10% for much of 2013 and 2014; in 2015 it rose to 10-15% and Bank of America-Merrill Lynch think that bullishness about the dollar is the most crowded trade in the markets at the moment.
Yet, that bullishness could be overdone. The dollar had a strong run in 2015, the strongest pace since the early ’80s, at that, and much of the positive bets are being made on the basis that the Fed will continue to tighten. It could be argued that much of that expectation has already been priced into the rise of the dollar against global currencies.
The Dollar’s Rise
What if it is overdone? A further rapid rise in the dollar could affect the US economy. Sure, it would reduce import prices, and hence inflation, but it would also cut export competitiveness and impact GDP. Stagnant GDP growth and weak inflation would, as we have seen not just in the US but in the UK and Europe, further delay interest rate increases by the Fed. The pretext for a stronger dollar would then evaporate and the “one way bet” could reverse sharply.
With the rest of the world expecting near-zero domestic interest rates, the probability of loose monetary policy, possibly further QE and the trend toward allowing previously fixed-dollar-peg currencies to devalue the divergence between the US and the rest of the world, will likely widen. Under those circumstances, a continued strengthening of the US dollar could negate pressure on the Fed to raise rates as far or as fast in 2016 as current expectations.