The Fed and the US Dollar
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.