Interest Rates Climbing

The dollar continues to reel
As traders collectively feel
That central bank timing
On interest rates climbing
Outside the US has appeal

Once again the dollar is under pressure as yesterday’s comments by Treasury Secretary Mnuchin continue to be main source of market discussion and questions arise as to whether the US is going to start using the dollar’s value as another policy tool. Given the efforts by the Administration to walk back the importance of Mnuchin’s comments and reiterate that they believe in a market-determined value for the dollar, I doubt that is the case. However, traders will be very alert to any further commentary regarding the dollar. Remember, President Trump has been very focused on the US trade imbalance and has mentioned the benefits of a weak dollar in that context. The funny thing is, the dollar has been falling for upwards of a year now without any Administration commentary, and so it seems unlikely that it is a focus for the US government. In fact, the story continues to be that although the Fed has been tightening policy for more than a year and is set to continue to do so, the big change has been the idea that other nations are starting to catch up and are beginning their own journey toward tighter monetary policy. In this reading, the FX market is simply anticipating the eventual higher rates we will be seeing from both Europe and Japan and buying those currencies now.

We have the potential to learn more about how this will play out in a short while as the ECB meeting concludes. While there is no expectation for any policy changes, thus the deposit rate will remain at -0.4% and the Asset Purchase Program will continue at €30 billion per month through September, all eyes will be on the language in the statement released and then even more keenly focused on Signor Draghi at the press conference following the meeting to see if he comes clean about what discussions are actually taking place. Some believe that the statement will remove the possibility that QE will be extended beyond the September date, which would be seen as another bullish euro cue. However, one thing to keep in mind is the old adage; buy the rumor, sell the news. It is entirely possible, if not likely, that the euro’s recent run-up already reflects this expectation and that if the statement is indeed changed, traders will take profits and drive the euro lower. Remember, that prior to the BOJ meeting earlier this week, expectations were growing for a change in the statement there as well, and although there were some subtle ones, clearly they did not satisfy the trading community who have only grown more anxious to see the beginning of the end of QE in Japan. As such, the rumor is still the driver with no news yet released.

I read an interesting take on markets yesterday that I think is worth sharing. This may get a bit arcane so bear with me. The idea is that the 30-year swap spread may be a harbinger of future market and economic activity and the fact that it is rapidly moving back toward positive territory is important. To begin with, the 30-year swap spread is the interest rate differential to exchange the payments between a fixed rate payment in a simple interest rate swap and a Treasury bond with the same maturity. The idea is that since there is no credit risk to hold Treasuries, one would need to receive a higher rate to accept the credit risk associated with a swap counterparty, which is typically a large bank. However, since the financial crisis, these spreads have been negative, meaning that accepting the credit risk of the bank resulted in a lower interest rate than owning Treasury bonds. On the surface, that doesn’t make much sense, but it was a reaction to the changes that occurred due to the crisis. As Kevin Muir, a well regarded trader and pundit explains, “Swap spreads dove because the supply of bank balance sheet was dramatically curtailed. Basically, banks, faced with more regulations and increased capital requirements, withdrew their participation in the swap market. The demand for swaps fell but not as quickly as the supply. The end result was that this mismatch of demand-supply meant that the previously unthinkable occurred, and swap spreads went negative. What would have usually been arbitraged away by proprietary trading desks at banks and other financial institutions was left to persist for years.”

So it is key to understand that this is a historically unusual situation, although it has been with us for the past nine years. It is important because it was an indication of how banks were managing their total balance sheets, meaning that they were husbanding capital and private credit was tight despite the fact that interest rates were low. The lack of private credit creation (aka bank loans) has been one of the features (bugs?) of the recovery from the financial crisis and has also been directly related to the decline in the velocity of money. That combination has arguably been behind the lack of measured inflation despite QE; the slow pace of economic growth; and the previous strength of the dollar. Well the reason I bring it up is because those spreads are racing back toward positive, which implies that private credit creation is making a comeback. Alongside that process we are likely to see inflation move higher as the supply of dollars that the Fed has created start to move around. The other likely outcome is that interest rates are going to go higher. Not only will this activity keep the Fed in active tightening mode, but the growth in demand for credit will push rates higher.

What does this have to do with the dollar? Well, there are two potential dollar drivers here. First, as the velocity of money increases, it will effectively create a significant increase in supply of dollars and therefore likely put further downward pressure on the buck. But at the same time, as interest rates rise, the appeal of the dollar for investors will increase. Currently the market is pricing in less Fed tightening than the Fed itself has penciled in. The narrative continues to be that quiescent inflation will prevent the Fed from having to raise rates aggressively. However, I would argue that inflation will not remain quiescent, that the Fed will find itself behind the curve before very long and they be forced to be more aggressive than they have currently planned, let alone what the market is pricing. Ultimately, if (when) the Fed becomes more aggressive tightening policy this year, look for the dollar to rebound.

As to today, aside from the ECB press conference, we see Initial Claims (exp 240K) and New Home Sales (680K), neither of which is likely to move markets. Meanwhile, the ECB statement was unchanged, so no hints about the future purchase plan that some had hoped for. However, the euro was little changed in the aftermath as all eyes are on Draghi at 8:30. My sense is that for now, the dollar will remain under pressure, with tomorrow’s GDP data, or more likely Monday’s PCE data the next chance for the narrative to come under pressure.

Good luck