An Air of Inevitability

One thing recent years have shown is certainly that currency markets have a tendency to overshoot and trend very consistently in the same direction. Sentiment and positioning analysis has in some cases failed to work with unwavering regularity. In fact, it didn't even help much if fundamentals were not necessarily in line with the trend – the yen being a prime example. Sentiment and positioning on the yen were at extremes for a long time, and while the BoJ has enacted an unprecedented “QE” operation, Japan's actual money supply growth has remained fairly tame. Not only that, according to John Hussman, the yen is now the most undervalued major currency on a purchasing power parity basis as well (note though that we are a bit wary of such data – how one can reasonably calculate PPP is hard to fathom given the vast array of prices in the economy).

Annualized growth of M1 (currency and demand deposits) in Japan. At a recent level of 4.8% it remains well below US and euro area money supply growth rates (7.6% and 6.8% respectively)

Of course, in the yen's case an argument can be made that the markets are punishing it for a perceived loss of quality, as the massive bond buying by the BoJ means the government owes ever more of its debt to itself – an absurdity that cannot remain without consequences forever. Recently Japan's government announced it would fund more building of bridges to nowhere, i.e., a huge stimulus package is to be enacted, which means that efforts to bring the debtberg under control remain postponed until further notice.

This brings us to the dollar's strong upward trend that has taken shape last year. Similar to the yen's downtrend, it has an air of inevitability. The Fed is seen as tightening monetary policy, while others are loosening theirs, or are experiencing an increase in risk aversion (this is the problem of a number of major commodity producing countries). Moreover, it cannot be denied that the dollar's trend looks technically strong.