The Fed and the US Dol­lar

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Now that the Fed­eral Re­serve has calmed down about the risk of a financial melt­down in China, only one fur­ther con­di­tion ap­pears to be nec­es­sary for a De­cem­ber rate hike: Oc­to­ber’s pay­roll fig­ures, out on Fri­day, must show an ap­pre­cia­ble re­ver­sion to­wards this year’s mean monthly growth of 198,000. That would im­ply Septem­ber’s sur­pris­ingly weak num­ber was a sta­tis­ti­cal aber­ra­tion, which seems a rea­son­able ex­pec­ta­tion, since most high-fre­quency in­di­ca­tors of US em­ploy­ment con­di­tions re­mained fairly strong through the sum­mer, in­clud­ing weekly un­em­ploy­ment claims, non-manufacturing PMIs and small busi­ness and con­sumer sur­veys.

Even last Fri­day’s 3Q GDP re­port showed no real ev­i­dence of a sum­mer slow­down, since the 1.5% head­line fig­ure in­cluded 1.4pp of in­ven­tory liq­ui­da­tion, while fi­nal de­mand and con­sump­tion con­tin­ued to grow ro­bustly, by 2.9% and 3.2% re­spec­tively.

Com­bin­ing this de­cent data with the Fed’s slightly more hawk­ish than ex­pected com­ments, mar­kets are right to price the prob­a­bil­ity of a De­cem­ber rate hike at over 50%. A strong pay­roll re­port on Fri­day could eas­ily boost that prob­a­bil­ity to 80% or even 90%. In any case, the im­por­tant ques­tion is not whether the Fed will make its first move in De­cem­ber, Jan­uary or March, but what ef­fect we should ex­pect from the start of the rate hike cy­cle.

In terms of di­rect im­pact on the US econ­omy, the an­swer must be “very lit­tle”. It is hard to imag­ine any eco­nomic model in which the dif­fer­ence be­tween short rates of 0.25% and 0.5% sig­nif­i­cantly af­fects de­ci­sions on con­sump­tion, sav­ings or in­vest­ment. What mat­ters to US eco­nomic ac­tiv­ity and em­ploy­ment is not the tim­ing of the first rate hike, but the speed and du­ra­tion of the tight­en­ing cy­cle, and — es­pe­cially — its ex­pected end-point. For all th­ese rea­sons, it would be bet­ter for tight­en­ing to start ear­lier, rather than later. The Fed’s re­peated prom­ises of an ex­cep­tion­ally shal­low and grad­ual cy­cle will be­come even more cred­i­ble once it starts to dis­play this grad­u­al­ism in prac­tice.

But what about the im­pact of the first Fed move on financial mar­kets and emerg­ing economies? Long-term bond yields have re­mained re­mark­ably steady as the spec­u­la­tion about a De­cem­ber rate hike has ebbed and flowed, pre­sum­ably be­cause bond in­vestors ex­pect the yield curve to flat­ten once the Fed shows it is will­ing to tighten, but tighten more grad­u­ally than ever be­fore. By con­trast, eq­uity in­vestors, cur­rency traders and in­ter­na­tional pol­i­cy­mak­ers are still jumpy. Their ner­vous­ness is hard to jus­tify. The start of this rate hike cy­cle will be one of the most pre­dictable — and pre­dicted — events in financial his­tory, in con­trast to the first rate hikes of 1994 and 2004, whose tim­ing sur­prised in­vestors and caused se­vere mar­ket volatil­ity. For this tech­ni­cal rea­son, cur­ren­cies and eq­ui­ties should be no more vul­ner­a­ble than bonds.

For fun­da­men­tal eco­nomic rea­sons too, eq­uity and cur­rency in­vestors should have lit­tle rea­son to worry. In prin­ci­ple, eq­ui­ties are in­flu­enced by rate hikes in two main ways: through eco­nomic ac­tiv­ity, and through the dis­count rate used to value fu­ture earn­ings streams. A 25bp move in short rates will not dam­age eco­nomic ac­tiv­ity, and may even boost con­fi­dence in the sus­tain­abil­ity of the ex­pan­sion. As for val­u­a­tions, they de­pend on long-term bond yields, not on overnight rates. So if bond mar­kets are calm at the prospect of the first rate hike, eq­uity mar­kets should be too.

That leaves cur­ren­cies. The con­sen­sus view is that the US dol­lar is sure to ap­pre­ci­ate once the Fed be­gins to tighten, es­pe­cially as the Euro­pean Cen­tral Bank and the Bank of Ja­pan con­tinue to print money. How­ever this con­ven­tional wis­dom may be mis­placed for at least five rea­sons:

1) The di­ver­gence of mone­tary poli­cies be­tween the US and Europe and Ja­pan has al­ready been thor­oughly priced into cur­rency val­ues, as shown by the al­most un­prece­dented cheap­ness of the yen and the near 14-year high in the US dol­lar (ad­justed for in­fla­tion), as shown in the chart.

2) Al­though mone­tary pol­icy set­tings and rel­a­tive in­ter­est rates are among the most i mpor­tant de­ter­mi­nants of cur­rency val­ues, they are not the only ones. Trade bal­ances also mat­ter, as do prospects for eco­nomic growth and cor­po­rate prof­its. On th­ese grounds, rel­a­tive to the US, Europe and Ja­pan are now look­ing more at­trac­tive than be­fore.

3) The US dol­lar has been in a bull mar­ket for seven years; the typ­i­cal length of cur­rency cy­cles since the 1972 end of the Bret­ton Woods regime. Fol­low­ing this pat­tern, the US dol­lar started ris­ing in April 2008, and looks as if it peaked in the first quar­ter of 2015.

4) While mar­ket an­a­lysts al­most uni­ver­sally as­sume a strong cor­re­la­tion be­tween mone­tary ex­pan­sion and cur­rency weak­ness, in re­al­ity the ev­i­dence for this cor­re­la­tion has been very mixed. While the yen weak­ened dra­mat­i­cally in 2013 and again in early 2015 in re­sponse to the BoJ’s quan­ti­ta­tive eas­ing, the euro has shown very lit­tle re­sponse to the ECB’s enor­mous QE pro­gramme, while the US dol­lar and ster­ling gen­er­ally strength­ened as their cen­tral banks ex­panded QE.

5) Look­ing at the two episodes of Fed tight­en­ing af­ter long pe­ri­ods of ex­cep­tion­ally easy money that be­gan in Fe­bru­ary 1994 and June 2004 — the only two events in financial his­tory broadly com­pa­ra­ble to the sit­u­a­tion in De­cem­ber if the Fed does start to move — we find that the US dol­lar strength­ened in the six months lead­ing up to each ini­tial rate hike, and then weak­ened sig­nif­i­cantly in the six months that fol­lowed.

Of course, two episodes do not make a sta­tis­ti­cally sig­nif­i­cant sam­ple. The fact that the US dol­lar weak­ened af­ter the last two oc­ca­sions the Fed be­gan to hike does not prove we are right to ex­pect the US dol­lar to weaken next year. It does prove, how­ever, that we are not ob­vi­ously wrong in ex­pect­ing a weaker US dol­lar. And in this busi­ness, it is a good start not to be ob­vi­ously wrong.

Putting all th­ese ar­gu­ments to­gether, it makes sense that the US dol­lar should rise strongly be­fore, not af­ter, the first Fed rate hike, in a clas­sic case of “buy the ru­mour, sell the news.”

If this turns out to be cor­rect, then fears about a global US dol­lar short­age, of a squeeze on in­ter­na­tional bor­row­ers with US dol­lar li­a­bil­i­ties, and of fur­ther down­ward pres­sure on emerg­ing mar­ket cur­ren­cies may turn out to be the sto­ries of 2015, not of 2016. If so, then the re­ac­tion of emerg­ing mar­kets to the Fed’s first rate hike, es­pe­cially in com­mod­i­ty­im­port­ing economies in Asia, should be much bet­ter than gen­er­ally ex­pected.

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