Some trends are so long-lasting, they seem like the natural order of things. Many people do not recognize them as trends at all; consider the longstanding belief that residential real estate prices never go down, or the one that was thrown at me by a student way back in 1997, "Stocks go up 15% a year!"
The dollar sinking against the euro has fallen into this category. This is amazing, considering how the common currency spent the first two years of its existence making one new low after another. But now the time has come to think about the unthinkable: that the euro's six-year uptrend may be over, at least on a trading basis.
As this outlook is based on the Federal Reserve ending its policy of negative real short-term interest rates, I must add the appropriate disclaimer to what would otherwise be a no-brainer forecast. If the Federal Reserve fails to carry through on its implicit promise to start fighting inflation, the dollar will turn south against the euro and do so with a near-biblical vengeance.
Interest Rate Expectations
Currency movements are driven by three factors: differential short-term interest rate expectations, differential returns on assets and financial flows. Those who look at just one factor tend to lose the big picture. For example, the yen could rise during its long era of near-zero interest rates on the basis of financial flows; importers of Japanese goods eventually had to buy yen to pay their suppliers. The yen also was supported by a perpetually steep yield curve at the money market horizon; while its three-month rates were tiny, the market persisted in believing they had to rise sometime in the succeeding six months.
Special factors have operated in the euro as well. We now recognize, in retrospect, how much of the euro's weakness in 2000-2001 was the so-called "mattress trade" of various legacy currencies being swapped out of soon-to-disappear cash and into dollars in a tax-avoidance scheme.
Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.
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