The Japanification of Germany: Dollar Rally Announces a Change in US Interest Rates

Historical experience shows that the dollar index gains considerable strength six to nine months before a change in U.S. interest rates. While a rate increase is currently not expected until mid-2015, the dollar is already making clear gains.

The euro’s decline against the dollar has intensified again in recent weeks. Since its annual high of nearly $1.40 on May 8, the European common currency has sunk 5.7 percent, to approximately $1.32. The past week’s losses were triggered by the speech of Mario Draghi, President of the European Central Bank (ECB), given during the tête-à-tête of international central bankers at a resort in Jackson Hole, Wyoming. Market observers have interpreted his statement as a shift in the central bank’s focus toward intensive attention to the labor market and a possible preliminary step ahead of European quantitative easing.

Short-Term Response?

In the meantime, from a purely technical perspective, the euro has been strongly oversold. Moreover, the currency has reached the bottom of its current trend channel, which began in May. Thus, one can minimally expect a short-term response. The positioning of market players on the futures market indicates the euro’s imminent recovery. Though speculation among “trend followers” over a falling euro is already very high, commercial market players have positioned themselves for an upward trending euro, as frequently happens when the currency hits a low point.

Conversely, the euro’s weakness is the U.S. dollar’s strength. This shift has increased through currency trading over the last three months. Though it appears strongly oversold from the point of view of the “greenback” (as the dollar is known in commercialese), many observers expect intermediate-term strengthening of the dollar.

Rate Hike in June 2015?

The measured, restrained rise in the dollar’s value is interesting in view of — and prior to — a potential slow change in American monetary policy. As historical examples demonstrate, market participants anticipate a change in monetary policy. In the past, they have begun to buy dollars around six to nine months before an impending cycle of interest rate hikes. This points to a comparison of the dollar index with U.S. interest rates.

The greenback climbed prior to interest rate cycles that began in February 1994, June 1999, and June 2004, respectively, each time about 7 percent. After the first rate increase, the trend then became more diffuse. The dollar-index measures the U.S. currency against a basket of six currencies of important trade partners. Weighted at almost 60 percent, the euro has the strongest influence within the basket. As such, the easing of the common currency against the dollar plays an important role for trends in the dollar index.

Counting back from May 2015, an interest rate cycle of the U.S. Federal Reserve would have to begin between November and February so that the dollar would stabilize over a period of six to nine months. As data from Bloomberg News indicates, retailers rely on fixed date contracts, which currently indicate a 56 percent probability that the U.S. Federal Reserve will begin to raise interest rates by July 2015.

Moreover, Fed records indicate that the open market committee has discussed the possibility of an earlier than expected rate increase, provided that the American labor market improves more quickly than expected.

Differences in interest rates between currency zones (as well as the development of said differences) have an important influence over currency trends. For example, the dollar rose strongly against the euro and the yen in 1999 and 2000. Back then, the U.S. prime rate sat at 6.5 percent, while those in the Eurozone drifted below 4 percent, and in Japan it stood virtually at zero. There are currently only marginal differences in the levels of prime rates, which stand at 0.25 percent in the U.S. and 0.15 percent in the Eurozone. A comparison of the rate structure curves, however, demonstrates that markedly higher interest rates are paid in the U.S. than in the Eurozone and in Japan. Measuring 10-year government bonds, the rate difference stands just short of 1.5 percentage points. American treasuries currently pay a return of about 2.4 percent against German Federal bonds, which only yield a 0.9 percent return. Ten-year Japanese government bonds are listed at 0.5 percent.

Decoupling the U.S.?

Furthermore, the comparison of interest rate structure curves of these three important industrial states indicates the coming Japanification of the German capital market. The interest rate curves of the largest European and Asian economies increasingly resemble each other. This arouses fears among market observers that Europe will develop a long, sustained disinflationary or even deflationary environment. This seems all the more valid as both states experience similar population trends.

The rate structure curve further indicates an increasing decoupling of the American economy from those of the Eurozone and Japan. One question could now be whether the U.S. economy will pull the other two up, or whether the two others will pull the American economy under. In any event, by virtue of the obvious trade ties, interdependencies are self-evident.