One of the problems of currency analysis is the way that when you are in the melee it is hard to tell the short-term fluctuation from the longer-term trend. It gets worse should you run into a crisis as Argentina found earlier this year as it raised interest-rates to 40% and still found itself calling for help from the International Monetary Fund. The reality was that it found itself caught out by a change in trend as the US Dollar stopped falling and began to rally. If we switch to the DXY index we see that the 88.6 of the middle of February has been replaced by 95.38 as I type this. At first it mostly trod water but since the middle of April it has been on the up.
If we ask the same question as Carly Simon did some years back then a partial answer comes from this from the testimony of Federal Reserve Chair Jerome Powell yesterday.
Over the first half of 2018 the FOMC has continued to gradually reduce monetary policy accommodation. In other words, we have continued to dial back the extra boost that was needed to help the economy recover from the financial crisis and recession. Specifically, we raised the target range for the federal funds rate by 1/4 percentage point at both our March and June meetings, bringing the target to its current range of 1-3/4 to 2 percent.
So the heat is on and looks set to be turned up a notch or two further.
the FOMC believes that–for now–the best way forward is to keep gradually raising the federal funds rate.
One nuance of this is the way that it has impacted at the shorter end of the US yield curve. For example the two-year Treasury Bond yield has more than doubled since early last September and is now 2.61%. This means two things. Firstly if we stay in the US it is approaching the ten-year Treasury Note yield which is 2.89%. If you read about a flat yield curve that is what is meant although not yet literally as the word relatively is invariably omitted. Also that there is now a very wide gap at this maturity with other nations with Japan at -0.13% and Germany at -0.64% for example.
At this point you may be wondering why two-year yields matter so much? I think that the financial media is still reflecting a consequence of the policies of the ECB which pushed things in that direction as the impact of the Securities Markets Programme for example and negative interest-rates.
QT or quantitative tightening is also likely to be a factor in the renewed Dollar strength but it represents something unusual. What I mean by that is we lack any sort of benchmark here for a quantity rather than a price change. Also attempts in the past were invariably implicit rather than explicit as interest-rates were raised to get banks to lend less to reduce the supply of Dollars or more realistically reduce the rate of growth of the supply. Now we have an explicit reduction and it has shifted to narrow ( the central banks balance sheet) money from broad money.
In addition, last October we started gradually reducing the Federal Reserve’s holdings of Treasury and mortgage-backed securities. That process has been running smoothly. ( Jerome Powell).
You can’t always get what you want
It may also be true that you can’t get what you need either which brings us to my article from March the 22nd on the apparent shortage of US Dollars. This is an awkward one as of course market liquidity in the US Dollar is very high but it is not stretching things to say that it is not enough for this.
Non-US banks collectively hold $12.6 trillion of dollar-denominated assets – almost as much as US banks…….Dollar funding stress of non-US banks was at the center of the GFC. ( GFC= Global Financial Crisis). ( BIS)
The issue faded for a bit but seems to be on the rise again as the Libor-OIS spread dipped but more recently has risen to 0.52 according to Morgan Stanley. What measure you use is a moving target especially as the Federal Reserve shifts the way it operates in interest-rate markets but they kept these for a reason.
In October 2013, the Federal Reserve and these central banks announced that their liquidity swap arrangements would be converted to standing arrangements that will remain in place until further notice.
Impact on the US economy
The situation here was explained by Federal Reserve Vice-Chair Stanley Fischer back in November 2015.
To gauge the quantitative effects on exports, the thick blue line in figure 2 shows the response of U.S. real exports to a 10 percent dollar appreciation that is derived from a large econometric model of U.S. trade maintained by the Federal Reserve Board staff. Real exports fall about 3 percent after a year and more than 7 percent after three years.
Imports are affected but by less.
The low exchange rate pass-through helps account for the more modest estimated response of U.S. real imports to a 10 percent exchange rate appreciation shown by the thin red line in figure 2, which indicates that real imports rise only about 3-3/4 percent after three years.
And via both routes GDP
The staff’s model indicates that the direct effects on GDP through net exports are large, with GDP falling over 1-1/2 percent below baseline after three years.
The impact is slow to arrive meaning we are likely to be seeing the impact of a currency fall when it is rising and vice versa raising the danger of tripping over our own feet in analysis terms.
What happens to everyone else?
As the US Dollar remains the reserve currency if it rises everyone else will fall and so they will experience inflation in the price of commodities and oil. This is likely to have a recessionary effect via for example the impact on real wages especially as nominal wage growth seems to be even more sticky than it used to be.
Responses to the situation above will vary for example the Bank of Japan will no doubt be saying the equivalent of “Party on” as it will welcome the weakening of the Yen to around 113 to the US Dollar. The ECB is probably neutral as a weakening for the Euro offsets some of its past rise as it celebrates actually hitting its 2% inflation target which will send it off for its summer break in good spirits. The unreliable boyfriend at the Bank of England is however rather typically likely to be unsure. Whilst all Governors seem to morph into lower Pound mode of course it also means that people do not believe his interest-rate hints and promises. Meanwhile many emerging economies have been hit hard such as Argentina and Turkey.
In terms of headlines the UK Pound £ is generating some as it gyrates around US $1.30 which it dipped below earlier. In some ways it is remarkably stable as we observe all the political shenanigans. I think a human emotion is at play and foreign exchange markets have got bored with it all.
Another factor here is that events can happen before the reasons for them. What I mean by that was that the main US Dollar rise was in late 2014 which anticipated I think a shift in US monetary policy that of course was yet to come. As adjustments to that view have developed we have seen all sorts of phases and we need to remember it was only on January 25th we were noting this.
The recent peak was at just over 103 as 2016 ended so we have seen a fall of a bit under 14%
Back then the status quo was
Down down deeper and down
Whereas the summer song so far is from Aloe Blacc
I need a dollar, dollar
Dollar that’s what I need
Well I need a dollar, dollar
Dollar that’s what I need
Me on Core Finance