BLUE PAPER. Why We Believe the US Dollar Will Remain Strong in IN BRIEF February 2015

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1 BLUE PAPER Why We Believe the US Dollar Will Remain Strong in 2015 IN BRIEF February 2015 Key engines behind a strong USD in 2015 Structural headwinds in full retreat, supportive capital flows and divergences in growth and monetary policy among G4 are, in our view, at the basis of another strong year for the US dollar. 1

2 BLUE PAPER Why Emerging We Believe Market the Bonds: US Dollar A New Will Thinking Remain Strong in 2015 May 2014 Key Insights Paresh Upadhyaya Senior Vice President, Director of Currency Strategy, US The US dollar bull market was surprisingly broad in 2014, gaining versus G-10 and EM currencies. Impressively, the USD trade weighted index rose about 12% - recording one of the largest appreciations since We believe there are many elements that should support a strong dollar in 2015 as well. First of all, as we have highlighted in past publications, we see some structural headwinds in full retreat, such as a massive slowdown in USD diversification and twin deficits at more sustainable levels. But new factors could play a role in 2015, such as capital flows. The catalyst behind the rebirth of capital flows into the US (both equity and fixed income) will likely be the great liquidity rotation where global investors or corporations could allocate investment decisions to asset markets not propped up by liquidity, such as Europe and Japan, but guided into markets supported by strong fundamentals, such as the US. M&A could be another supporting factor: we continue to view the pick-up in M&A activity as a positive development for the USD as a consequence of the huge amount of cash held by US corporations and of the competitive advantage in the energy field. Growth and monetary policy divergences among G4 will likely serve as another key engine behind a USD bull market in The Bank of Japan (BoJ) will maintain aggressive monetary easing via Quantitative Easing (QE) as well as the European Central Bank (ECB) that announced in January a massive balance sheet expansion for the coming months. In contrast, the US ended QE in October 2014 and is expected to hike interest rates during the second half of Similar policy actions are expected by the Bank of England (BoE). Therefore, the combination of relative divergences in central bank balance sheets and the likely start of the rate hiking cycle in the US are expected to be another supportive factor for the US dollar. Contributors Paresh Upadhyaya is Director of Currency Strategy, U.S. He leads Pioneer Investments currency research effort out of Boston and serves as an advisor to the firm s global fixedincome and equity investment staff on currency-related issues. In addition, he helps lead sovereign credit analysis and advises the investment team on sovereign bond investments. He is a member of Pioneer s 29-person U.S. fixed income team. Paresh has 19 years of experience in the investment industry. He joined Pioneer from Bank of America Merrill Lynch, where he was Director, Senior FX Strategist Head of North Americas G- 10 FX. Prior to BofA Merrill Lynch, he was a Portfolio Manager and member of the currency team at Putnam Investments, where he participated in actively managing $20 billion in currency investments in currency overlay, fixed income, global asset allocation, and international equity portfolios. He has a B.S. in Economics and International Relations from Boston University and an M.B.A. in Finance from Boston College. 1 Source: Bloomberg, data as of January 20,

3 % Change US Dollar Bull Market Set to Continue in was a monumental year for the US Dollar (USD). In our Blue Paper, published in August 2013, we highlighted the structural factors coming together to trigger a multi-year USD bull market (divergences in G4 monetary policy, changes in global Foreign Exchange (FX) reserve growth, adjustments in twin imbalances). As we predicted, there has been a significant rally in the USD, effectively breaking a 41-year downward trend. The USD bull market was surprisingly broad, gaining versus G-10 and EM currencies. Impressively, the USD trade weighted index rose about 12% in 2014 recording one of the largest appreciations since 1974 (Chart 1). In this Blue Paper, we update the main structural changes discussed in prior Blue Papers and introduce new factors (capital flows, growth and new monetary policy divergences) that will likely provide renewed energy for the USD bull market to carry on into Chart 1: USD Trade Weighted Index Source: Bloomberg,Pioneer Investments,as of December 31, Structural Headwinds in Full Retreat Massive Slowdown in USD Diversification This was an important structural factor cited in our previous Blue Papers that is no longer a headwind for the USD. There continues to be a significant slowing in global foreign currency reserve growth, which we believe will have an immediate impact, slowing the demand for USD diversification. World reserve accumulation grew a paltry 1.9% yoy in December 2014, well below the historical average of 15.2%. More importantly, the region that has witnessed the fastest reserve accumulation and thus greater need for USD diversification has been Asia. We estimate that Asian FX reserves grew by just 0.5% yoy in December 2014 the lowest ever and well below the long-run average of 15.4% 2. Notably, China s FX reserve accumulation has fallen 2.6% since its peak in June We believe the decline in China s FX reserves could be a structural change given China s gradual deceleration in growth and policies implemented to reduce FX reserve growth, i.e., more trade denominated in Renminbi (RMB). 2 Source: Data from Bloomberg, ECB as of January 20,

4 Twin Deficits At More Sustainable Levels This was the other structural factor cited in our Blue Papers and since its publication, there continues to be further improvement in the fiscal and current account deficit. The fiscal deficit has narrowed from 4.2% of GDP in June 2013 to 2.8% of GDP in September 2014, while the current account deficit has improved from 2.6% to 2.2% during this period. The Congressional Budget Office (CBO) projects fiscal deficits averaging 2.8% in the period , rising only slightly to 3.2% for However, the current account deficit still has room for further improvement, and there is the potential for the deficit to move to a balance in the coming 5 years. The shale oil/gas revolution has been the main driving factor behind the shrinking current account deficit. The oil balance as a percentage of the total trade deficit has fallen dramatically from 66% in March 2011 to 35% in October Despite the recent sharp decline in oil prices, we expect this trend to continue, although possibly at a slower pace. 2. Capital Flows We believe capital flows will be one of the key new drivers behind the continuation of the USD bull market in The catalyst behind the rebirth of capital flows into the US will be the great liquidity rotation, in which global investors or corporations will likely allocate investments to asset markets not propped up by liquidity, such as Europe and Japan, but rather to markets supported by strong fundamentals, such as the US. These capital flows are likely to entail portfolio inflows, Merger and Acquisitions (M&A) and quite possibly Foreign Direct Investment (FDI). We will explore the potential reasons why this early trend is likely to gather momentum in the coming months. Global Macro Fundamentals: A Robust Backdrop for the USD The 2015 outlook for GDP and CPI continue to highlight the ongoing divergences within the G4 (Table 1). The US is projected to be the fastest growing economy in the G4, growing about 2% higher against the EU and 3% against Japan, while besting the UK by 0.6%. With respect to CPI, the US is the closest to its target, while the others remain well below their central bank targets. It is this CPI outperformance that helps the US outshine its peers in the G4. Table 1: Pioneer Investments Forecasts for GDP and CPI for 2015 US EU Japan UK GDP 3.4% 1.6% 1.2% 2.8% CPI 1.5% 0.3% 0.4% 1.3% Source: Pioneer Investments forecasts, data as of January 31, In our view, there are tentative signs that net equity inflows and US investor selling of foreign bonds are poised to provide a meaningful tailwind to the USD. According to our analysis, these flows have a robust impact on the USD. Net Equity Inflows Emerging From January 2013 to May 2014, there have been consistent strong net equity outflows from the US. However, that appears to be turning with huge net inflows for 3 out of the last 4 months. The net equity outflows reached a standard deviation 3 of 4.3 that 3 Standard deviation is a measure of the dispersion of a set of data from its mean. The sentence means that net equity outflows are quite high compared to historical averages. 3

5 Jan 90 Aug 91 Mar 93 Oct 94 May 96 Dec 97 Jul 99 Feb 01 Sep 02 Apr 04 Nov 05 Jun 07 Jan 09 Aug 10 Mar 12 Oct 13 Sep 14 Bln $ we believe is not sustainable. The rolling 12-month cumulative outflows have started to narrow dramatically from a peak of $270.3bn on March 2014, to $105.9bn in September 2014 (Chart 2). We believe the USD could see a replay of the strong equity-induced rally of for the following reasons: US investors have been selling their overseas equity holdings on concerns over a deteriorating global growth outlook, prospects for deflation and a stronger USD Foreign investors have been buying US equities on the relatively strong fundamentals i.e. above trend growth, stable inflation picture, etc.(table 1) Japan s Government Pension Investment Fund (GPIF) reforms will likely lead to new flows into the US equity markets. GPIF announced that the foreign equity allocation will be doubled to 25%. According to JP Morgan and Pioneer estimates, this could lead to a potential net inflow of $54.5bn in Chart 2: Cumulative Net Equity Inflows into the US USD Index USD Index (RHS) Source: US Treasury, Pioneer Investments, last data point as of September Since January 2014, US investors have been steady sellers of overseas fixed income instruments in 8 out of 10 months. This is beginning to have an impact on the longer term trend, with rolling 12-month cumulative inflows turning positive in October at $69.1bn (Chart 3). We believe the USD could appreciate as US investors begin to pick up selling in overseas fixed income assets similar to the early 2000 s and during spikes of risk aversion in 2008 and 2012 for the following reasons: In the post quantitative easing (QE) era s search for yield, US investors have been pouring money overseas, but there are signs this buying has plateaued The rate normalization process in the US should trigger higher Treasury yields which will create upward pressure on global yields, especially in EM. 4

6 Bln $ Cumulative 12 Months Jan 90 Jul 91 Jan 93 Jul 94 Jan 96 Jul 97 Jan 99 Jul 00 Jan 02 Jul 03 Jan 05 Jul 06 Jan 08 Jul 09 Jan 08 Jul 09 Jan 11 Jul 12 Jan 14 Bln $ Chart 3: Cumulative Net Bond Inflows USD Index Foreign Bonds USD Index Source: US Treasury, Pioneer Investments, last data pointas of October M&A activity has picked up to its highest level since 2007, totaling $1.01tn (Bank of America estimates). Many of the M&A targets have been in Euroland and the US. A notable development for 2014 has been the sharp pickup in European acquisitions of US companies (Chart 4). We continue to view the pick-up in M&A activity as a positive development for the USD, and expect it to continue for the following factors: Global Multinational Corporation (MNC) balance sheets are flush with cash. This should continue to entice MNC s to acquire strategic assets overseas. The relatively robust US fundamentals will make it a more attractive place for M&A Bank of America and UN research has highlighted that the shale revolution has been the key driver behind the pickup in M&A activity in the US, most notably by Euroland companies trying to gain expertise and technological know-how from US firms. While the decline in oil prices could adversely affect future capex intentions, weak oil prices could raise the attractiveness of oil/shale firms as acquiring firms may be attracted by cheap valuations. Chart 4: Net Cross-Border M&A Moving in Favor of US vs EU Source: Bank of America, last data point as of November While we have highlighted portfolio flows and M&A as the main forces propelling the USD higher from a capital flows perspective, FDI is likely to be a wild card. Since the early 2000 s, net FDI has reflected steady outflows from the US, and as a result has been a persistent headwind for the USD. In the pursuit of globalization, US MNC s have been 5

7 Jun 06 Jul 07 Aug 08 Sep 09 Oct 10 Nov 11 Dec 12 Jan 14 Feb 15 Mar 16 Jan 06 Aug 07 Oct 08 Dec 09 Fep 11 Apr 12 Jun 13 Aug 14 Oct 15 Dec 16 investing overseas, while the lack of a compelling investment story or sector in the US led to more modest overseas FDI in the US. However, potential tax reforms could provide incentives to US corporations to repatriate overseas earnings for investment purposes, along the lines of the Homeland Investment Act of 2005 that led to estimated inflows of $125bn during the fourth quarter. We think the probability of a similar act being passed is less than 50%, but it would be strongly positive for the USD. 3. G-4 Monetary Policy Divergences There will be sharp divergences in G-4 monetary policy that, we believe, will serve as another key engine behind a USD bull market in The Bank of Japan (BoJ) will maintain aggressive monetary easing via QE, while the ECB announced in January a massive balance sheet expansion for the coming months. In contrast, the US exited QE in October 2014 and is expected to hike interest rates during the second half of Similar policy actions are expected by the Bank of England (BoE). The combination of divergences in central bank balance sheets and the likely start of the rate hiking cycle in the US is expected to be another supportive factor for the US dollar. Differences in G-4 Balance Sheets With QE being a new instrument in monetary policy, it is probably too early to determine a statistically significant relationship between expansion of a central bank s balance sheet and the currency. The transmission mechanism from this qualitative relationship goes as follows: a central bank buys their domestic bonds and help keep interest rates depressed which in turn leads to a weaker currency. The following charts 5a and b show this fairly robust qualitative relationship, which is also reinforced by a quantitative model as explained on page 9. The two charts show a ratio of the Fed s balance sheet to that of the BoJ and ECB (expressed as % of GDP) along with the FX relationship. For the most part, the charts indicate that as the Fed s balance sheet expanded from 2008 to 2012, the USD weakened and vice versa. Chart 5a: Fed/BoJ Balance Sheet Ratio and USDJPY Chart 5b: Fed/ECB Balance Sheet Ratio and EURUSD Internal Projections Fed/BoJ BS Ratio(LHS) USDJPY(RHS) Fed/ECB BSRatio(LHS) EURUSD(RHS) Source: Central Banks database, as of January 20,2015.Balance sheets as % of GDP. 6

8 According to our projections, we expect the Fed and BoE balance sheets to hold steady in nominal terms in 2015 and 2016, while declining as a percentage of GDP. On the other hand, we expect the ECB to implement sovereign QE in Q and therefore for its balance sheet to rise through We also expect the BoJ balance sheet to rise during this period. As a result, we forecast the Fed/ECB and Fed/BoJ ratio to decline in 2015 and 2016 which, assuming the prior relationship continues, will lead to further EUR and JPY depreciation versus the USD. Based on balance sheet forecasts, the USD has the potential to conservatively hit 1.05 versus the EUR and against the JPY. Yield Curve and Interest Rate Differentials likely to be USD Supportive Changes in the slope of the yield curve do impact the USD. We conducted a weekly analysis of the 2yr-10yr US Treasury and bucketed the changes in the slope into 4 categories bear flattener, bull flattener, bear steepener and bull steepener. Our analysis of the results reveals the USD tends to appreciate in a bear flattener environment, where 2yr yields are rising at a faster rate than 10yr yields. On the other hand, the USD tend to depreciate in a bull steepener period where 10yr yields are declining at a faster rate than 2yr. Our research analysis shows no meaningful USD appreciation or depreciation in a bull flattener or bear steepener (Table 2). Table 2: USD Performance to Changes in the Y ield Curve1 Bear Flattener Bull Flattener Bear Steepener Bull Steepener 10/10/80-12/19/ % 0.03% 0.02% -0.36% Source: Pioneer Investments, BofA, as of December 19, In 2014, we witnessed a bear flattener in the 2yr to 10yr part of the US Treasury curve. From a year ago, yields rose in short end of the curve while yields declined in the long end. In our opinion, this was one of the key factors driving the USD strength last year. As we look ahead to 2015, we expect to see another bear flattener - perhaps a more pronounced one, especially in the first half of The key driver behind the bear flattener will be the expected start to the Fed s tightening cycle. Currently, we think the market is expecting only 2 hikes in 2015 while the Fed s dots (anonymous rate projections) suggest at least 3. Given the robust macro fundamentals for the US in 2015, there is a risk the Fed will hike more than the market currently projects. During the first half of 2015, we expect the continued strong US macro data to exert upward pressure on the short-end of the curve, while benign inflation will keep long term rates relatively stable. However, in the second half of 2015, we could see more upward pressure on the long-end as wage and inflationary pressures may emerge from capacity constraints such as tight labor markets and capacity utilization. The gap between 2yr and 10yr yields narrowed markedly in 2014 and is projected to narrow further in 2015 based on consensus forecasts (Chart 6). A positive figure represents that short term interest rates are higher than long term interest rates - a sign of an inverted yield curve. 1 Bear flattening indicates a situation in which short term interest rates are increasing faster than long-term interest rates. Bull flattening indicates an environment in which long-term rates decrease faster than short-term rates. In a bear steepening scenario long-term rates rise faster than short-term rates, while in bull steepening short term rates fall faster than long-term rates. 7

9 01/96 12/96 11/97 10/98 09/99 08/00 07/01 06/02 05/03 04/04 03/05 02/06 01/07 12/07 11/08 10/09 09/10 08/11 07/12 06/13 05/14 US Ger Spread, % % Chart 6: Trend in Bear Flattening Set to Continue Q1 Q2 Q3 Q Source: Pioneer Investments,Bloomberg, as of December An additional factor to consider which is also supporting the dollar is the increase of interest rate differentials between US and other developed markets which are seeking to reflate their economies through QE. In Chart 7 we show the evolution of the US-Germany 5 year rate differential and the euro-dollar currency ratio. We utilize the 5 year because we believe it is likely to be the middle ground, influenced both by shorter-term central bank rate expectations and longer term growth expectations. Chart 7: EURUSD Supported by the Widening of US-Germany 5y Spread EURUSD Rate US-Ger 5Y Spread (LHS) EURUSD (RHS), Reverse Order Source: Pioneer Investments, Bloomberg,as of December The relationship is strong and it clearly works in favour of the dollar. 8

10 US Ger Spread, % A Quantitative Assessment of the USD Dynamics Exchange rates are typically much more volatile than economic fundamentals. However, analyzing the long-term trends can provide the appropriate framework to differentiate structural moves from temporary swings and noise. Moreover, factors that generate currency misalignment may vary in every cycle and across pairs. Gabriele Oriolo Global Asset Allocation Research Analyst If we focus on the recent history of the EURUSD and USDJPY crosses (since 2008), we can see that one of the elements that drove the exchange rate dynamic in the recent cycle was the different approach of the Central Banks in managing their balance sheets. The Fed, the BoJ and the ECB injected net liquidity into the system for $3.6tn, Yen189tn and 640bn, respectively. Such a difference in the pace of balance sheet expansion determined, among other factors, the relative strength the Euro experienced vs peers in the aftermath of the peripheral crisis. Chart 8: Central Banks Assets as % GDP Japan US Euro Area Source: Bloomberg, Pioneer Investments forecasts as of January 23,2015. The recent decision of ECB President Draghi to expand the balance sheet by 60bn per month ( 1.14Trn), from March 2015 to September 2016 (and possibly beyond) is one of the factors that we believe will most impact the EURUSD currency trend in the next twelve months. In the following pages, we aim to assess how much of this change is already priced in at current levels (at the time of writing EURUSD=1.12). To achieve our goal, we use a modified version of a famous academic model, the Monetary model with sticky prices. Monetary models encompass purchasing power parity (PPP) and interest rate parity assumptions. With these models, we try to estimate the equilibrium exchange rate that should equate to the relative money demand and supply conditions between the two economies. Excess relative monetary easing, assuming it spills over to prices, requires a weaker exchange rate. On the other hand, all else being equal, higher income requires a stronger currency through money demand conditions. The flexible version of the monetary model assumes that equilibrium in goods and asset markets goes at the same pace. However, in practice, due to the dynamic nature of capital flows and price stickiness in goods prices, asset markets clear much faster, and can lead to currency overshooting (à la Dornbusch, hence the sticky monetary model). In our modified version, we don t use broader monetary aggregates (M2 or M3) which cannot be directly controlled by Central Banks, but we include the relative Balance Sheet expansion by Central Banks (the so-called M0) in order to detect its direct impact on the exchange rate. 9

11 Table 2: To Assess the X-rate Value We Consider the Following Macroeconomic Projections for 2015: U.S. Euro Area Japan Rate Policy B/S Macroeconomic Target Hiking cycle starting in summer (i.e. 2015Q2). We expect 50bps hike this year End of B/S expansion ended 2014Q4. No need to shrink it. Real GDP growth 3.4%. Inflation 1.5% Source: Pioneer Investments, forecasts as of January 31, Refi Rate held at 0.05 in bln/m of B/S sheet expansion till September Trn as a whole. Real GDP growth 1.6%. Inflation 0.3% Benchmark Rate on Hold QQE: Yearly Y80Tln of B/S sheet expansion. Real GDP growth 0.4%. Inflation 1.2% According to our model, remarkable divergences in the macroeconomic backdrop, with real growth in US decoupling and Eurozone inflation around flat in 2015, together with unprecedented monetary policy divergences, will further drag down the EURUSD fair value. Therefore, we believe that for the coming months a target for the EURUSD in the range of could be the most likely scenario. With regard to the Yen, we assess the equilibrium levels at about 125 vs USD and 130 vs Euro. Such figures reveal that the cross is already discounting Kuroda s quantitative and qualitative easing (QQE) almost entirely (Yen Trade Weighted Index depreciated more than 30% since 2012). Conclusion We expect that the USD will be well supported in 2015 and, importantly, guided by new variables, such as capital flows and relative divergences in G4 monetary policy. 10

12 Important Information Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of January 31, Unless otherwise stated, all views expressed are those of Pioneer Investments. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any services. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: February 10, Follow us on: 11

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