The currency market is a close relative of the bond market, a sister if you will. Trends or volatility in one market can impact the other. Much of this has to do with sovereign monetary policies, inflation prospects, and currency speculation and interest rate carry trades. Thus, bond market participants often pay close attention to currency markets and vice versa. I am no exception.

Since peaking on 11/30/15 (at 100.17 on the DXY index), the value of the U.S. dollar has steadily declined versus most major currencies. Risk market bulls have lauded the decline as ushering in a new period of U.S. corporate prosperity. I.E. A weaker USD should help U.S. multinationals by making U.S. goods cheaper overseas. It was also expected to help foreign exporters, particularly energy and materials exporters, by pushing up the prices of commodities. However, noticeably missing from recent earnings releases were optimistic earnings guidance for future quarters. This has left many market participants confused.

That CEO/CFO earnings guidance for future quarters has not been all that optimistic is not surprising to me. All that needs to be done is to understand why the USD has weakened and foreign currencies have strengthened. The reason the USD has weakened is two-fold:

1) After raising the range of the Fed Funds Rate 25 basis points last December, the Fed has remained on the sidelines for the first three meetings of 2016. Fed statements and minutes have sounded decidedly dovish.

2) In spite of massive and extraordinary monetary stimulus by central banks around the world, particularly by the European Central Bank and Bank of Japan, foreign currencies (especially the JPY and EUR) have rallied. That the yen and euro rallied after the latest rounds of extraordinary monetary policy accommodation is, in my opinion, a sign of economic stress.

The Grateful Death Embrace

Why would the currency markets view extraordinary monetary policy accommodation as a sign of stress? Think about it. Moving to negative interest rates is both a sign of desperation and a journey into uncharted territory. In times of uncertainty, investors and consumers in countries experiencing economic slowness and uncertainty tend to move capital to safer assets, typically domestic sovereign debt, bank deposits, etc. When rates are low or (now) negative, consumers may hoard cash. We are seeing that in both Europe and (especially) Japan.

Another phenomenon often materializes when the largest economy in a region (trading area) experiences economic discomfort. Money from investors residing in regional trading partner nations of the large troubled economy often move capital into the currency and sovereign debt of the what they presume the safest regional economy. Thus, we often see capital flow into the Japanese yen when there is economic trouble in Asia, even when Japan is a (or the) source of concerns. That China is also creating uncertainty in the region is another reason that some regional investors might move money into the JPY.

Capital flows into a currency can be both due to disinflation/deflation as well as a cause. If capital continues to flow into a currency/economy, it can create increased disinflationary forces which, in turn, may cause more capital to flow into the currency. Thus, a positive feedback loop for currency valuation can form. Of course, for central banks wishing to boost growth and inflation, an appreciating currency can be a negative feedback loop.

This negative-positive feedback loop augurs for weaker foreign demand for goods and services, including those made in the United States. Much as a dog chasing its tale, a weaker dollar might be chasing weaker foreign demand, which makes the dollar weaker. The weaker USD makes foreign currencies stronger, which sparks disinflation/deflation and may quash economic growth and consumption in foreign economies. Thus, global economies become entangled in a kind of death embrace.

A form of a death embrace scenario is my base case scenario. Unless economies experience pro-growth fiscal and economic policies, central banks will do what central banks can do, but that will probably prove insufficient, if not counterproductive. The problem with counting on fiscal and regulatory reform is that is that such reforms would require a scaling back of benefits, entitlements and job protections. In economies with aging populations, such as Japan, Europe and even the United States, such reforms have proved unpopular. In the end, it is the citizenry who are ultimately causing the secular stagnation they abhor and fear.

This is not rocket science folks. You can’t have massive changes in demographics, technology and globalization and expect traditional policies to deliver expected results. The economic game has changed. To the many readers, industry peers and financial journalists who have asked me when and how much I expect interest rates (both long and short) to rise, my response is: You should be at least as concerned about falling global interest rates as rising global interest rates.