Dollar gets clobbered during first quarter in surprise twist

This was not supposed to happen while in the middle of a US dollar upswing. The greenback was the second-worst performing major currency during the first quarter, besting only the beleaguered UK pound which is facing big political and economic risk in June in the form of the EU in/out referendum.

Interestingly, two currencies whose central banks took stimulus action during the first quarter; the yen and the euro, did relatively well. Particularly the yen was the best performer despite the Bank of Japan’s historic step to take one of its key interest rates in negative territory. The BoJ move that took place in January was not welcomed by neither the markets nor by Japanese banks and the public.

One could say that the yen attracted safe haven flows because of the intense volatility during the first few weeks of 2016. Why then did those flows not reverse when stocks and other risky assets managed to climb out of the hole they found themselves in early February? Furthermore, why did the yen not respond to disappointing economic data that will probably lead to even more stimulus by the Bank? Some answers to these nagging questions should be provided in the course of the coming months. One could speculate that both because of extreme short positioning and the extent of the yen’s previous weakening (dollar / yen bottomed at 77 back in 2012), pushing the yen even lower as the Bank of Japan might have intended was a very difficult task to accomplish.

This is perhaps a point that is applicable to the euro as well. The European Central Bank proceeded with unprecedented measures during its recent March meeting such as reducing interest rates further into negative territory, increasing the size of its monthly bond purchases and expanding the scope of those purchases to corporate bonds. In addition, the ECB is planning long-term financing operations, during which some banks will actually get paid to borrow money. Instead of plummeting, the euro managed to rise. Investors should ask themselves therefore how much the euro / dollar decline from 1.40 to 1.10 has priced in so far and whether additional monetary stimulus from the ECB going forward will manage to push the euro substantially lower. Euro / dollar, one of the most closely watched currency pairs, managed to post gains of nearly 5% during the first quarter despite the aggressive easing action from the ECB.

Euro / dollar’s gains however were also a result of US dollar weakness. Despite the fact that most US economic data during the first quarter was relatively decent, the Fed dealt dollar bulls a big blow by citing global risks in paring back its outlook for rate hikes during 2016. Policy divergence trades have been favoring the US dollar as the Fed was potentially the only major central bank in the world looking to raise rates in 2016. This looked like a less certain bet after the Fed’s March meeting and after a speech this week by Yellen herself during which she stressed the need for a cautious approach to interest rate hikes.

Where does this leave the markets going into the second quarter? The euro’s and the yen’s gains and the respective losses by the greenback appear to be more of a reaction to some extreme levels and misplaced confidence in the Fed to hike rates in a series of moves once it made the first move back in December. However, it might be difficult to find catalysts that could lead the yen and the euro to sustained uptrends while the Japanese and Eurozone economies are still facing such serious challenges and are looking for more stimulus. Therefore a period of range-bound action is still looking more probable than a breakout even though euro / dollar and dollar / yen are presently probing their 5-month high and 15-month low respectively.