EC Divergence, Linear Thinking And The Dollar

December will be a month to remember. ECB President Draghi continued to fan expectations of further accommodative measures at the December 3 meeting.  At the same time, the strength of last week’s US employment report, reinforced by comments from the Fed’s leadership, has convinced many that lift-off is likely a fortnight after the ECB meeting. Following the jobs data, a Reuters poll found 15 of 17 primary dealers expect the Fed to hike rates next month.

Analysts and journalists have scrambled to look for the last time the Fed and European policy moved in opposite directions in the same month. What happened? The US dollar continued sell-off. Some are using this experience to push against the dollar bullish view that prevails. 

There are several problems with this logic. First, while we respect the effort to look at past divergences, there is simply too small a sample set to derive any meaningful conclusion.  

Second, academic studies have repeatedly found that forwards, which are based on interest rate differentials are poor predictors of future currency movement. In 1994, the German Bundesbank cut rates, the Federal Reserve hiked, and that dollar did not rally. This seems to simply confirm what the academic studies suggest.  

Third, foreign exchange and interest rates are two dimensions of the price of money. Of course, there is a relationship. The problem is that the relationship is not linear. Yet many observers insist on thinking linearly. Think cycles. Here is an idealized version. The US economy weakens. The dollar retreats. The Fed cuts interest rates. The dollar sells off further. US market rates may begin to rise (in relative or absolute terms) to compensate investors for the currency risk.   

After some time and reiterations of this part of the cycle, the economy begins finding traction.  The dollar remains weak. The Fed raises rates. The dollar may stay weak. After some unspecified period, the dollar begins recovering as the investors appreciate that they are over-compensated for the currency risk and interest rates ease.