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Christian Broda Explains FX Markets

When many expected the dollar to continue to depreciate over the foreseeable future, a few experts, notably Christian Broda, predicted the dollar could strengthen in 2010, if the Federal Reserve exited quantitative easing (QE). This was contingent on the US economy enjoying a strong rebound. The exit never happened. The economy was anemic, but the dollar still strengthened. Why were so many pessimists about the US dollar so wrong?

Now that the Federal Reserve may actually exit QE, the natural conclusion is the dollar should strengthen even further. This is the same conclusion many arrived at in 2010, but the underlying fundamentals are still the same. Japan is still doing QE and Europe has been opening up the possibility in recent weeks. The difference is that the US economy is much stronger than in 2010, so it would seem wise to keep your investment in the US.

When the Fed exits, usually there is trouble in EM and many are now thinking twice about following the conventional wisdom emerging markets (EM) are the place to put your money. Conventional wisdom following the monetary collapse of 2008 has proven to be suspect at best. The hesitation to dump US dollars for EM currencies is prudent.

In 2009, most industry professionals feared the inevitable end to so much money printing would be a spike in inflation. This would cause a rise in the price of gold and a steep decline in the strength of the US dollar. With the Fed pumping trillions of dollars into the economy how could there be any other outcome?

Many celebrities and financial experts in 2009 predicted the US economy would be racked by high inflation when the inevitable recovery began. Authorities as diverse as Harvard historian, Niall Ferguson, and famous hedge fund investor John Paulson were openly stating the only possible outcome from so much QE would be massive inflation. Indeed Professor Ferguson wondered if the U.S. was becoming Argentina, so racked by inflation it would cripple any recovery. The Wall Street Journal suggested, as the American economy improved, the risk of inflation would skyrocket.

There were the experts that were on the price deflation side. The Nobel Prize-winning Op-Ed (opposite the editorial page) columnist Paul Krugman wrote: “And what these measures show is an ongoing process of disinflation that could, in not too long, turn into outright deflation… Japan here we come”. This theory was widely publicized by the New York Times and others who used the threat of deflation to justify the continuance of QE policies in recent years.

What happened? Why are we not paying for our daily fix of coffee with newly minted $50 and $100 dollar bills? Why are US consumers unable to buy the same “cup of joe” for a quarter? If all the experts were wrong, who is right?

Hindsight has a way to weed out the extreme views and find those that offer a more moderate, and accurate tone. Among those not believing the sky was falling back in 2009 was Christian Broda, now a managing director at a $12bn hedge fund and Ethan Harris, Chief Economist at BoFa. Their paper speculated the then-current market forces would conspire to make low inflation the outcome for a long period. Time it seems has declared their view the winner as inflation has remained under their prediction of 5% for the past 4 years. If you had followed their advice, you might not be sitting on piles of $1800 an ounce of gold.

What does this mean for FX markets if the US dollar remains strong? If the Fed exits QE while others such as Japan and Europe continue to inflate their economies will the US dollar head to unchartered highs? Will there be a backlash as exports from the US are unable to compete with lower priced markets?

The key to this question resides in how quickly the Fed will taper. This is the point at which the Federal Reserve reduces its $85 billion monthly purchases of Treasuries and MBS and is considered the crucial first step before the support ends and is eventually reversed. Once the Fed decides to taper its purchases, the effect on FX markets will become apparent. Only then can the opinions of experts on both side of the inflationary divide be judged.

What the past 4 years of prognostications has shown is those who take extreme views are often using past historical declines to predict future events. This year many are calling for a measured taper from the Fed and a continued strong US dollar as the economy improves. Taking a moderate position in 2014 could be the safest. Moderation is the key to prosperity; it certainly is according to Christian Broda.