The scene looks set for the US Federal Reserve to start raising interest rates in 2015 – a shift in the monetary cycle, which could unleash more turmoil in currency and other markets, such as equities. It will also highlight increasing divergence between the US and the eurozone and Japan.
The US economy is in good health and could grow faster in 2015 than it did this year. It will be further helped by the recent collapse in oil prices putting more money into the pockets of all important US consumers. As in previous economic cycles, the US is likely to be able to shrug off the poor economic outlook in much of the rest of the world as most of its demand tends to be domestically generated rather than relying on exports.
At the same time, unemployment levels are likely to continue falling, and next year they should reach levels which could see the beginnings of wage inflation. Once the effect of lower oil prices has worked its way out of the CPI numbers, the US Federal Reserve will have less reason for restraint on interest rates. These are likely to start increasing in H2.
The effect of US interest rate rises – or at least the anticipation of them coming, which the Fed is likely to telegraph to the market ahead of it happening – will unleash further volatility. This could put more downward pressure on vulnerable emerging market currencies and spark a big sell-off in equities markets, which seem the least prepared of the major asset classes for the coming change in US monetary policy.
The test for the Fed is whether it will tighten regardless of 'rate rise tantrums' and push ahead on the basis that a normalisation of monetary policy is actually a very good sign in that the real economy can take it.
The forex markets seem better prepared for the change in US monetary policy, which has been reflected in the soaring USD, which is not just down to the end of Fed's quantitative easing programme, but also in anticipation of US interest rate rises. Indeed, when they do come, there could actually be a sell-off of USD as traders take profits as anticipation has become news. Nonetheless, it is unlikely to fall very far or for that long as USD should remain a holding currency of choice given the US's strong economic fundamentals.
Political uncertainty will weigh on GBP
In terms of economic performance, the UK had a very good year with job creation progressing at a good pace. Indeed, at one point it looked as if the UK could beat the US at being the first of the major economies to increase interest rates. That looks increasingly less likely with the pace of UK economic growth likely to be slower than recent numbers, but still healthy.
In May, the UK faces a general election and predicting the likely winner(s) has become difficult due to the country's fragmenting political landscape. The rise of the two single issue policy parties, the Scottish National Party (wants independence from UK) and the UK Independence Party (wants UK to leave EU) will greatly complicate the outcome of the UK election, possibly leading to a hung parliament.
The issuing political uncertainty will weigh on GBP. The other negatives are the perpetual lack of growth in the Eurozone, which is helping to keep the UK's current account deficit at high levels due to a lack of export prospects across the Channel. However, migration from the stagnating Eurozone could also keep downward pressure on UK wages, which have made only very modest gains despite strong jobs growth. This removes any urgency to hike interest rates.
However, falling oil prices will prove to be a tonic for the UK economy. In the short term it could see UK inflation falling to very low levels or even into temporary deflation. As long as the UK economy is performing well, the Bank of England is unlikely to resort to a new economic stimulus programme. One area to watch would be a renewed run-up in UK real estate prices.
Given the headwinds facing a relatively healthy UK economy, interest rate rises probably won't happen until Q4 and several months after a US rise. So although GBP may not make much headway against the USD, it should be able to hold its own against the other majors.
Likely trading range for GBP/USD: 1.5300-1.6000 with 1.5500 acting as strong support.
The battle to re-start eurozone economy will heat up
H1 if not Q1 should see the European Central Bank begin a quantitative easing programme as that seems to be the tool most likely to quickly increase inflation and inflation expectations. Though ECB President Mario Draghi very clearly wants to do it, he is up against deep divisions within the central bank and strong German reticence, which could even lead to legal action.
The ECB will also continue to favour a weaker EUR, which will have a knock on effect on other European currencies, particularly CHF and SEK and to a lesser extent GBP. This could create regional tension as other European central banks feel obliged to keep pace with EUR depreciation.
The eurozone is mired in stagnation and appears to be heading for deflation, which could unleash problems with heavily indebted Italy. In a deflationary environment, the real value of debts increases, placing increasing strain on borrowers.
Falling oil prices, which will increase deflationary pressures, will sway the argument in favour of doing QE. However, lower energy prices, if maintained, should help the eurozone economy, as should the strong US economy. Both should counter-act the effect on exports of sanctions against Russia and the slowing Chinese economy.
It's actually possible that the eurozone could deliver a surprise in terms of economic performance during H2 – once factors, such as lower energy prices and QE have worked their way into the real economy. Also, lower energy prices will increase the size of the eurozone's already large current account surplus. Nonetheless, the eurozone remains stuck with many structural issues and increasingly dire population demographics, which will continue to be a drag on growth.
Likely trading range for EUR/USD: 1.1500-1.2500 with strong support at 1.2000.
Markets will begin to question Japanese policy
The actions of policy makers in Japan look increasingly desperate in the face of the dramatic quantitative easing programme by the Bank of Japan. Its size was increased in 2014 and it could be ramped up further in 2015, not least because the giant Government Pension Investment Fund is going to be switching out of much of its JGB holdings into equities and assets abroad.
The main cause of Japan's constant inability to grow sustainably and its deflationary environment stems from its rapidly ageing population, which is also set to shrink – something that no amount of monetary stimulus can reverse. Meanwhile, a lack of reforms has allowed debt to GDP to spiral towards 250% with the fiscal situation becoming increasingly unsustainable.
The government is attempting to improve its fiscal position by for example raising taxes, which so far has dented the fragile economy. The hope is that a lower JPY and BoJ QE will rekindle enough growth so more taxes can be collected, but for reasons stated earlier this looks unlikely to work long-term.
The big concern is that BoJ's QE will increasingly resemble an attempt by the central bank to finance the government's expenditure rather than to re-inflate the economy – especially if the economy keeps lapsing back into recession.
Indeed, the real risk is that the economic policies of Shinzo Abe, the Japanese Prime Minister, will lose credibility in 2015 or 2016. The fall-out could be disastrous for Japan as investors begin to question the country's ability to service its debts, which will hammer JPY. This could be one of the big economic stories of 2016 and it could begin to creep up in Q4, 2015.
In the meantime, a sinking JPY will cause central banks in South Korea, Taiwan and even China to also suppress their currencies for fear of losing share of export markets to Japanese companies.
Likely trading range for USD/JPY: 120-130.
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