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The Dollar and the Fed


The Dollar and the Fed

One of the stark developments since the initial shock of the pandemic has been the aggressiveness of the US monetary and fiscal response. This was also true in dealing with the Great Financial Crisis. The divergence then and now had shaped the investment climate.

On a per-capita basis, the pandemic struck the US harder than in most other high-income countries, and some see the wide disparity of income and wealth as a contributing factor. In any event, the vaccine rollout has been quite good by international standards. This, coupled with vigorous policy support, economic activity has exploded.

A growing chorus of economists has argued that the Fed ought to target nominal GDP. Two percent inflation, which the Fed targets at 2% (now on an average basis, but no term for the average has been declared) and three percent real growth, has been an elusive but desired goal. In nominal terms, the US economy grew by more than 10% annualized in Q1, and it appears well above that here in Q2. In fact, after the disappointing employment report, the Atlanta Fed’s GDP tracker sees Q2 real GDP at 11% annualized, down from 13.6% prior to the employment report. The NY Fed’s tracker slipped to 5.1% last week from 5.3%.

Many high-income countries contracted in Q1 but are recovering, and positive growth is likely going forward. The acceleration of the US economy is still quicker, meaning that the divergence may extend a bit longer. However, the real takeaway from recent news and developments is that the divergence meme is ending. In fact, models of data surprises show the US faltering and Europe improving and can only be underscored by the nonfarm payroll report. In addition, the vaccine rollout in other high-income countries is accelerating, and Europe’s seven-day average has surpassed the US. Partly, this is a function of catching up after a slow start. However, there is another issue that is unfolding. A significant minority appear reluctant to take the vaccine.

As we have come to appreciate, herd immunity does not require everyone is vaccinated. The greater the contagion, the greater the percentage of people needed to have immunity. It is possible that some areas, and even states, may fall shy of the coverage that doctors and scientists say is required to achieve herd immunity. In the US, the vaccines are still regarded as for emergency purposes only, making it difficult for public authorities to force the issue. Making the vaccines not just for emergencies could make it easier to impose greater social ostracization on those who refuse a vaccine. While the modern libertarian spirit may be the force behind attempts to decentralize finance, the public health crisis seems to push in the opposite direction.

We have anticipated that the divergence meme morphs into its opposite, namely convergence. However, another divergence is opening and one in which the US is the laggard. The Federal Reserve’s leadership says it too soon to even talk about talking about adjusting the open spigot of monetary policy by slowing the pace of bond purchases from the current $120 bln a month pace. Canada has also begun the process of tapering. Last week, Norway’s central bank reaffirmed its intention to raise rates before the end of this year. The Bank of England said it would slow its weekly bond purchases and look to complete them this year.

There will be a vigorous debate next month at the ECB about the pace of its bond purchases. Several of the more hawkish members apparently want to slow from the stepped-up pace agreed to in March. New staff forecasts at the meeting will likely revise up their growth forecasts and take into account the spillover of the significant US fiscal stimulus. The Reserve Bank of Australia may also be in line ahead of the US to adjust its policies. In July, it will decide whether to extend its yield-curve control to the November 2024 bond and about a new bond-buying program.

With the strong fiscal support, the pent-up demand, the vaccine, the re-opening, the Fed’s stance seems to stretch credulity. While April’s employment data were terribly disappointing, and the 146k downward revision in March’s estimate shows recovery in the labor market is not a powerful as it had appeared. Cleaning the weekly initial jobless claims from fraudulent filings may have exaggerated the decline in filings, but it also exaggerated the increase. Weekly initial jobless claims fell below 500k at the end of April for the first time since March 2020. The four-week was 866k at the end of January.

Unlike the downside of a business cycle, the problem might not be on the demand side of the labor market but the supply side. Without schools and daycare fully open, many who might be taking new positions or returning to old positions cannot. Others may still be reluctant due to the virus and availability and confidence in public transportation. Like the Chamber of Commerce, some called for the end of the federal government’s $300 weekly supplement unemployment compensation to address what anecdotal reports suggest is a labor shortage.

After the Great Financial Crisis, it took five years for the unemployment rate to fall below 6%. It stood at 6.1% last month after falling to 6% in March. It has more than halved from last year’s peak. After the Great Financial Crisis, it took six years from the peak in unemployment to be reduced by half. The underemployment rate fell to 10.4% from 10.7% in March. In the GFC, it peaked in 2009 and was not under 10% until late 2015.

The April retail sales and industrial production reports will shed light on the meaning of the disappointing employment data. Does it signal a slowing of the US economy? Did the fiscal buzz wear off, as some are suggesting? The strong, strong auto sales hint at a healthy retail sales report, but the employment data seemed to have spooked some economists who reduced their forecasts. March’s record US trade deficit showed businesses anticipating strong consumer demand. Manufacturing employment fell by 18k instead of rising by 54k as the median forecast in Bloomberg’s survey had it, and some revised down their forecasts for manufacturing output/industrial production.

The other target is inflation. Next week the April CPI and PPI will be released. Whether price pressures prove temporary, reasonable people may differ, but what seems to be clear is that threat of deflation has all but disappeared. The year-over-year CPI rate stood at 2.6% in March and is expected to have jumped to 3.6% in April. This is partly the base effect, as the last April’s decline drops out of the 12-month comparison.

The average monthly increase of CPI in Q1 was a little more than 0.4%. This is picking up the impact of the supply chain issues and shortages. The median forecast in Bloomberg’s survey was for a 0.2% increase in April. Over the last 10 years (120 months), US CPI has averaged a 1.7% increase and 2.3% over the past 30 years (360 months). The similar core rate averages are 1.9% and 2.3%. The averages capture the broad trend of lessening price pressures and how closely they track each other on a medium and long-term basis.

Producer prices jumped 1% in March for a 4.2% year-over-year rate. Bloomberg’s survey’s median forecast is for the monthly rate to slow to 0.2%, but the year-over-year rate to accelerate to 5.8%. A little more than a third of the year-over-year increase stems from food and energy, which, if stripped out, should around a 3.7% year-over-year pace in April. This means that the cost of inputs, including packaging and transportation costs, are rising. As a result, one of three things, or more frequently it seems, a combination takes place, costs passed on to the consumer, narrow profit margins are accepted, perhaps to maintain market share or productivity increases.

The point, again, is that the threat of deflation has been exorcised. The first debate is not about removing monetary stimulus. It is about slowing the amount of new accommodation by reducing the bond purchases. In Japan, quantitative easing via Rinban operations before the Great Financial Crisis was the norm, but in the US, the purchase of long-term assets is about triage, but now the patient has had a large fiscal and medical vaccine, and some extra monetary vitamins, and is beginning to run. Therapy is still needed, but triage, less so.

While the Fed’s leadership is reluctant to signal that it may begin considering reducing the pace of its bond purchases, the Treasury will auction $126 bln of coupons in next week’s quarterly refunding. The primary dealer system obligates the necessary buying. However, the auctions can be sloppy–low bid cover, a large tail, an immediate post-auction decline in yield, as we have experienced with the sale of the seven-year note earlier this year.

Given the size of the budget and current account deficits, the US has to offer a combination of higher interest rates or a weaker dollar. The Federal Reserve is blocking the former and is willing to accept the latter. Among the high-income countries, the US 10-year note has performed best over the past month. The yield has fallen by almost 10 bp, while European yields have risen 10-27 bp.

In addition to the signals from the 10-year, look at what has happened to the December 2022 Eurodollar futures contract. The implied yield trended higher in Q1 and peaked in early April around 53 bp (cash is around 16 bp), almost 35 bp higher than it had begun the year. The dollar generally trended higher in Q1. Since early April, the yield has trended lower and took another big step down after the employment disappointment. The implied yield traded near 37 bp before the weekend, essentially unwinding this year’s increase. The dollar has been tracking the yield lower.

Tapering is not tightening, but the market knows, and the Fed knows that the market knows that tapering is the first step toward tightening. The Fed may not want to signal tapering because it does not want markets to run with it and tighten financial conditions prematurely. Fed officials appreciate arguably, if not better than Wall Street, that there is no free lunch; there are trade-offs. The disequilibrium will be addressed by either higher interest rates or a lower dollar, or a combination.

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Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.
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