NEW YORK — Market veterans who watched the dollar weaken during Federal Reserve tightening cycles in 1994 and 2004 say this time may be different.
For one thing, central banks own at least $3.9 trillion of reserves in dollars and are unlikely to unload the greenback, as investors did in 1994. The theme of policy divergence, which played a role in past cycles, is prominent again. This time around it may favor the dollar — the Fed is moving toward normalizing borrowing costs as central banks in Europe and Asia keep policy accommodative.
Following are five observers’ takeaways regarding the past three periods of Fed tightening and the path ahead for the $5.3 trillion-a-day currency world as the central bank considers raising its target from near zero. Their comments were made in separate interviews in the past week and have been edited to form a narrative.
_ The participants:
–Adnan Akant joined Fischer Francis Trees & Watts Inc. in 1984. He’s now head of currencies at the New York-based money manager.
–Kit Juckes worked at S.G. Warburg in 1994. He’s now a global strategist at Societe Generale SA in London.
–Jonathan Lewis joined Skandia Asset Management in 1988 and was a money-market trader at Dean Witter Reynolds. He’s now chief investment officer at Samson Capital Advisors LLC in New York.
–Bob Savage spent 23 years at Goldman Sachs Group Inc., where he headed macro foreign-exchange sales. He’s now chief executive officer of hedge fund CCTrack Solutions LLC in New York.
–Jennifer Vail is head of fixed-income research in Portland, Oregon, at U.S. Bank Wealth Management, where she’s been since 2004. She was previously with Morgan Stanley.
_ 1994-1995
WHAT HAPPENED: This rate-increase cycle was the fastest among the three. Seven years into Alan Greenspan’s tenure as chairman, the Fed doubled its target rate to 6 percent in 12 months.
The dollar rallied 0.9 percent on the day of the first increase, but went on to drop 8.4 percent by the last move, as measured by Intercontinental Exchange Inc.’s U.S. Dollar Index. The speed of the tightening caught investors off guard, spurring one of the worst annual routs ever for 10-year Treasuries and declines in equities.
Akant: They gave us six to nine months of pre-discussion of how they would have to raise rates soon, and of course the minute they raised rates 25 basis points, all hell broke loose.
Juckes: People were forecasting a rate rise; what they weren’t forecasting was the extent of the fall in dollar-yen or the speed and strength of the selloff in the Treasuries market, which caused a huge amount of pain.
Savage: At Goldman, it was a horrible year. It was one of the few times when they actually lost money. 1994 was probably one of the peaks of my career in terms of being a big-shot trader.
LESSONS FOR 2015: Investors could again be caught off guard if inflation accelerates and fuels a quicker pace of tightening than they’re pricing in. However, there’s a difference this time around: while international investors still own the majority of U.S. government debt, the makeup has changed.
Akant: Keep in mind in those days it was the private sector holding U.S. bonds. Now it’s a lot more reserves held by central banks in dollars and that’s a different dynamic. I don’t think central banks are going to necessarily aggressively sell the U.S. bond market to avoid losses. They might be selling to support currencies like in the case of China, but it’s a different dynamic than ’94.
Vail: The reason that you see the dollar fall sometimes after liftoff is because it is a tightening of financial conditions, and that tends to slow things down a bit because the access to easy money has been reduced. You could even say this in ’94.
_ 1999-2000
WHAT HAPPENED: Market turmoil preceded the June 1999 rate increase: the Asian financial crisis prompted three Fed rate cuts the year before. As financial conditions stabilized worldwide, the Fed raised rates to 6.5 percent from 4.75 percent over 11 months.
While the dollar fell 0.2 percent on the day of the first increase, it gained 8 percent by the end of the cycle, helped by European investors piling into U.S. stocks following the introduction of the euro. The dollar’s bull run ended following the burst of the dot-com bubble in 2000.
Savage: The thing that really created the stock bubble was the euro. The euro allowed a universal power to invest in the U.S. It’s the first time stock-market flows mattered more than interest-rate flows in the dollar’s history.
Lewis: The euro was really extraordinarily weak and that helped turbocharge that dollar rally.
LESSONS FOR 2015: There are echoes of 1999 this year. Asia, and emerging markets as a whole, are grappling with economic slowdown and an exodus of money. The euro is again on its back foot as the European Central Bank’s accommodative policy encourages flows into the U.S.
Lewis: Sometimes the rally isn’t about the Fed story and what the Fed’s doing, but about the weakness in others.
Savage: The 1999 hikes were taken as good. The economy was back on track. In some ways, I think that mood could be the same if we get a rate hike this year. It’ll be taken as a sign of strength rather than a sign of weakness.
_ 2004-2006
WHAT HAPPENED: By 2004, the economy had shaken off the end of the dot-com bubble. The Fed began a steady cycle of rate increases — 25 basis points every meeting — that took borrowing costs from 1 percent to 5.25 percent over two years.
The dollar dropped 0.7 percent the day of the first hike, and it lost 3.9 percent over the course of the cycle. The economy was strong in the U.S., but investors worldwide were pouring money into carry trades, where they borrowed in low-rate nations and invested in higher-yielding assets in Europe and emerging markets.
Vail: Greenspan was battling an economy that was firing on all cylinders. He faced a record-high housing market, unemployment that was in the low single digits and inflation. And that’s not a battle that Yellen has to face. The trajectory of the recovery has been much more sluggish.
Juckes: We quickly dismissed the 2004 cycle as something that wouldn’t stall the recovery. Rates were going up slowly from a very low level and we went off in search for yield.
Akant: People were excited about buying other foreign assets. U.S. investors were going global and investing their assets into emerging markets.
LESSONS FOR 2015: Contrary to the experience of 2004, carry trades may bolster the U.S. currency now. With central banks in Europe and Japan keeping interest rates near record lows, the Fed has little company as it prepares to raise its benchmark. The divergence may attract investors.
Savage: The amount of money that went abroad out of the U.S. made a lot of sense in that U.S. investors wanted diversification. The difference today is there’s plenty of yield to have out there, but yields are high for a reason. The situation now is very different.
Akant: The interest-rate environment hasn’t really been the reason for the dollar rally: it was really more the relative economic position of the U.S. being strong and the promise of monetary-policy divergence.
