The week ahead is among the most important of the year.  Rarely is there such a confluence of events in a short period that will have far-reaching implications for investors that are known ahead of time and have been discussed so extensively. One implications of this is that there are expectations that have been discounted by the market.

The potential for sharp price gyrations and the dictates of money management should not distract from the big picture and the durable trends. In this context, there are two important considerations long-term investors ought to keep in mind.

First, the divergence in the trajectories of monetary policy has not peaked, or even come close to a peak. If we agree this is the main driver in the foreign exchange market, then further dollar appreciation on a trend basis should be anticipated. There has been a dramatic re-build of long dollar positions since mid-October. The late momentum traders are vulnerable in the period ahead. It may occur after this week’s events, or it may be after the FOMC meeting later in December. Such a shakeout may provide long-term investors with a new opportunity to position with the underlying trend.

Second, while all Fed tightenings do not lead to a dollar rally, the Reagan dollar rally and the Clinton dollar rally (the previous two significant dollar rallies since the end of Bretton Woods) were preceded by Fed rate hikes. Recall Volcker’s hikes prior to the 1980 election helped set the stage for that dollar rally that ultimately lift the greenback more than 50% on a real trade-weighted basis before coordinated G7 intervention reversed it.

The Fed raised rates in 1994. This, combined with a new Treasury Secretary that promised not to use the dollar as a trade weapon, spurred the five-year Clinton dollar rally. It too ultimately ended with the help of coordinated intervention in October 2000.

Here is a thumbnail sketch of next week’s seven key events:

1.  China’s November PMI readings:  Expectations little changed. The manufacturing economy likely slowed while the service sector continues to expand. The economy is transitioning away from manufacturing so the traditional go-to metrics, like railroad car loadings, electrical consumption, and bank loans, were picked by Premier Li at an earlier stage of development. Market impact is likely to be minimal. The China stock and bond markets are trading on another dynamic than the macroeconomic condition. The equity market posted a dramatic loss before the weekend, but the global knock-on effect seemed minimal and the US S&P 500 eked out a small gain.  Often negative economic surprises from China weigh on commodity producers including the Australian dollar.

2.  IMF’s SDR decision: It seems like a forgone conclusion now that the IMF will include the yuan in the next configuration of the SDR, which will be implemented in September 2016.  Assuming this is a reasonable surmise, then the real question is about the weighting of the yuan. This is very much unknown in part because, as the IMF is the first to admit, it is not a mechanical decision. There is a large judgment component. The literature suggests the IMF’s own approach has been evolving toward more weight on capital markets than the market for goods (exports).  Also, the other currencies in the SDR are substantially more accessible and used than the yuan.  

If just relying on China’s exports, the IMF staff suggested in the summer, a weighting of 14-16%. Many observers seemed to have taken this illustration out of context, and this became the rough consensus of what will be announced.  We are less sanguine. From China’s point of view, the key now is getting in, not the weight. That is where there is scope for compromise with those who think that yuan is not seasoned sufficiently, and much more work has to be done to increase the role of markets in setting key elements of the price of money in China. Also, there is some discomfort with the light capital controls that China has imposed to deter capital outflows.