In 2019 the major central banks have been focused on reflating markets by either pausing or reversing plans for policy normalization (higher rates) that hit many markets hard in 2018. Despite ongoing fears of slowing global growth, equities and commodities have so far responded positively to the prospect of easier rates and more plentiful liquidity.
But the one thing that could ruin the party is the strength of the dollar. In my opinion the rising USD was an underappreciated factor that squeezed many regions hard last year, especially emerging economies with current account deficits. Many of these entities had borrowed heavily cheap dollars at low rates under the Fed’s QE program after the 2008 recession, leaving their fiscal position vulnerable as the dollar rose. Not only does it make debt repayment and refinancing more expensive, it also tends to pressure commodity prices that these countries often rely on for exports, creating an unenviable situation where the things they are short (dollar debt) go up and the things they are long (raw materials) go down. And as 2018 proved, because global markets are more interconnected than ever, it wasn’t long before problems in the emerging markets became a problem for the developed markets.
Normally, you would expect that the dovish shift at the Fed this year would undermine the dollar. I certainly did. As it became more apparent that the highs were in for interest rates in early Q4 last year, I assumed the same for the dollar. It was a perfectly logical conclusion given that major currencies often track the path of underlying interest rates. Wrong. Except for a few shallow dips, the dollar has been remarkably resilient. It even shrugged off the appointments of inflation doves Steve Moore and Herman Caine. In the currency world it remains the best of a bad lot and the safety and liquidity it offers in uncertain times can’t be matched. Being short hasn’t cost much money so far but the longer it remains here at the top of its range, the probability grows that the next move is higher.
The chart of the dollar index (DXY) is potentially very bullish, and a break above 97.75 would signal the beginning of a (perhaps significant) leg up. This would unleash a deflationary impulse, and much like in 2018 leave stocks and commodities vulnerable. The world needs a weaker dollar to keep the 2019 bull reflation trade going. But it may not get it.
Here in Washington, DC, packing the courts is a charge frequently used by both parties to accuse political opponents of trying to influence judicial outcomes by getting their guys of similar ideology seated on the bench. This comes to mind with news that President Trump intends to elevate Herman Caine to join recently-appointed Steve Moore to the Fed https://on.wsj.com/2CX3vBv. By putting forward two notable inflation doves (and political allies,) it’s clear that the President is trying to tip the balance of power on the board to favor a more market-friendly composition. Wasting no time, Moore called on the Fed to begin cutting rates immediately https://cnb.cx/2uvSWRm.
Late last year as global growth slowed and equity markets stumbled badly the president made no secret of his feelings toward the Fed, blaming them for having no ‘feel’ for market conditions as they continued to methodically raise rates https://reut.rs/2ONDd9M . The data since then suggests Trump was right. As the stimulative impact of last year’s tax cuts fades and signs of weakness in the economy intensify, Trump is leaving nothing to chance. For a president that often references the Dow as a benchmark for economic policy success, he intends for the Fed to be his electoral insurance policy.
Until recently the Fed had been generally dismissive of the trend toward a flatter yield curve and the negative implications it carried for the trajectory of inflation and the economy, choosing instead to trust that the rising tide of a robust labor market would push prices higher and continue to justify the steady march toward policy normalization from post-recession extremes.
But this week a red flag appeared in the market that will be hard for the board to ignore. The benchmark 2yr treasury yield fell below the Fed’s main policy rate, a sure sign that despite official forecasts the peak of the current rate path is rapidly approaching, if not having already passed. Economic cycles have unknowable but finite lifespans. Even though the current expansion that began in June 2009 is only a few months from being the longest in history, the inversion in rates suggests the possibility that the old record may be safe.
At the upcoming March 19-20 policy meeting the Fed will be forced to address the large and growing gap between their own projections and the outcome being embraced by the short-term rate complex. The Summary of Economic Projections (SEP) last updated in December foresaw two rate hikes in 2019 and one more in 2020, ultimately putting the current Fed Funds rate of 2.40% at around 3.125%. The problem for chairman Powell is that over that same time period the market is not only not pricing in rate hikes but an easing instead, discounting a lower year-end 2020 overnight rate of 2.15%.
Having learned from the experience of the bond market massacre in 1994 triggered by a surprise hike in rates the Fed has not since tightened unless the futures market has priced in at least a 70% chance of it happening https://bit.ly/1Khc3xm. Seeing that market-based odds for any further rate hikes over the next couple of years is essentially zero the economy would have to rebound sharply to put any further tightening into play. It’s not impossible but a highly unlikely scenario at this late stage in the expansion.
Reconciling the difference with the marketplace is a tricky proposition for the Fed. The market is clearly pushing them to ease but without more evidence of economic weakness they are reluctant to abruptly reverse course and jeopardize their credibility by perhaps being too reactive to the normal ups and downs in growth. In addition to that they risk being seen under the thumb of the president Trump, who late last year criticized current policy and chastised them for not having a good feel for the economy and markets https://nyti.ms/2T936Bh.
The lesson of 2018 is that in an increasingly inter-connected global economy, policies of the major central banks can diverge for only so long before something snaps, and the convulsions in the equity markets late in the year were a sign that a breaking point had been reached. Rising rates and an accompanying strong dollar exposed many corporate and sovereign entities to the perils of having leveraged themselves with cheap USD funding under quantitative easing.
Ongoing geopolitical and trade uncertainties now require the Fed to be a force for stability, not a source of volatility. A backstop for global economic weakness. While the board won’t fully embrace easier policy next week they will take the market’s lead and begin making baby steps in that direction. Investors should take this as further evidence that a top in rates and the dollar is in place and that any talk of higher rates is just that…..talk.
The Trader’s Perspective is written from a trader’s perspective of risk versus reward. The goal is to simplify the process of macroeconomic analysis and look for opportunities beyond consensus opinion.