The Dollar and Deflation

Written by Bruce J. Clark

April 29, 2019

Friday’s better than expected number for first quarter GDP may be dominating the headlines but it’s the report on Personal Consumption Expenditures that is driving the market reaction. Prices paid by consumers for goods and services, excluding volatile food and energy components, fell sharply in the first three months of the year, extending a decline that began at this time last year (see chart below.) The big drop in US bond yields on the week despite otherwise good news for new home sales, durable goods orders and growth, in general, is a sign that global deflationary forces are gaining an upper hand.

It wasn’t supposed to be this way. In theory, robust growth, rising wages, and full employment create greater aggregate demand that leads to higher prices and higher inflation. Ever since the Fed began raising rates in 2015, tighter monetary policy has been predicated on this basic economic assumption.

The disconnect isn’t limited to the US. Some foreign central banks are beginning to panic as inflation fails to respond to years of stimulative policy. This past week Japan and Sweden joined a growing list of countries putting off any chance of rate hikes in 2019. See here: https://reut.rs/2GI0gjI and https://reut.rs/2IUj6pv . The problem is that like Europe and Switzerland, they too have already imposed negative interest rates and are running out of options to kickstart growth.

Credit to the Fed for pursuing a course of policy normalization over the past few years. They planned ahead. Part of the rationale for raising rates was to make room for rate cuts in the event of a slowdown. While this gives the US a distinct economic advantage on the world stage it doesn’t necessarily mean it will produce a happy ending.

As I mentioned in (See “Good news, bad news) the downside in this scenario of divergent global growth is that it will drive the dollar higher against the world’s other currencies. In fact, it has already begun. While the equity markets are still celebrating a good Q1 earnings season, the risk going forward now shifts to the negative impact a stronger dollar will have on the bottom line as it makes American exports less competitive. It also starts to turn the screws on entities that leveraged cheap dollars at low rates during a decade of Fed largess. In my opinion, the aggregate short exposure to the USD is grossly underestimated.

The most efficient way to express the view of intensifying deflationary pressure is to own both the dollar and treasuries. The 2-year sector is especially attractive as a play on possible rate cuts and as the flattening trend in the yield curve of the last couple of years begins to reverse (see chart below).