While the USD Index has already gained around 12% in the latter half of 2014, we expect this momentum to continue. The USD follows an interesting trend known as the 'dollar smile.' According to this theory, the value of the USD is determined by three phases. When economies are slowing down, investors become risk averse and instead of investing in risk assets, they flee towards the USD, a safe haven currency, no matter what the state of the US economy is because US government securities provide certainty. This causes an appreciation of the USD. The second scenario occurs when the US economy weakens; as GDP and interest rates decline, so does the USD. Lastly, the third scenario arises when the US economy is in a phase of recovery; as economic fundamentals strengthen, so does the USD. By laying this theory on markets today, it seems that the USD is strengthening due to the third scenario as we continue to see a steady recovery in the US.
This surge has several implications. While imported manufactured goods become cheaper, the increase in the volume of imports does not necessarily cause a deterioration of the trade balance. The effects should be limited on the trade deficit and benign for inflation. One major effect of a strong US dollar is on commodity prices. As energy prices are expressed in USD, a stronger dollar implies lower commodity prices, particularly in the energy segment. While this is not the only reason oil prices are plummeting, a stronger USD is generally correlated with lower oil prices. Together with this effect, weakening demand from emerging economies and OPEC's surprise decision to refrain from rebalancing markets further deepened the plunge in oil prices. To withstand this situation, some oil exporters may expand production and depress global energy prices further in order to satisfy their revenue requirements. However, exporters such as Venezuela that have no spare capacity and are relatively high cost exporters will be the worst hit. Conversely, net energy importers, especially emerging economies that subsidize fuel such as India, will be the winners.
On the other hand, Russia entered currency crisis mode. While the Russian central bank has hiked rates from 5.5% in January to 17% in December, the rouble plummeted more than 50% in the same time span. Plunging oil prices, which are taking a toll on Russia's revenues and exports, along with western sanctions over Russia's intervention in Ukraine, are working concurrently to push Russia into a possible recession in 2015.
The Japanese yen has been depreciating in the midst of further monetary stimulus as the Bank of Japan extended its qualitative and quantitative easing (QQE) programme. While the main result of Abenomics has been a weaker yen, which has significantly boosted the profits of Japanese companies, to date it is not materially benefitting the Japanese consumer.