A Brave New World?

Could it be the yen’s
Recent strength is testament
To a brave new world?

While the dollar is broadly stronger this morning, the ongoing zeitgeist remains one of future dollar weakness. After last year’s standout performance by the euro, it seems traders and investors are turning their sights now to the yen. And though the yen is weaker this morning by 0.5%, it has still gained more than 5.0% YTD. The question remains what, if anything, can derail the broad based view that the dollar is set for an even steeper decline as the year progresses?

Contemplate the following thought experiment. The situation is that the last three major inflation readings (CPI, PPI and Import Prices) have been far higher than expectations, and so have the price indices in both the Philly Fed and Empire Mfg. surveys. Now consider you are a member of the FOMC and it is March 21st. You look at the following current data: Core PCE 1.8%, Unemployment Rate 4.0%, GDP +3.0%, and S&P 500 2800.

This grouping has your preferred inflation target virtually met, as well as rising rapidly; an unemployment rate below your view of NAIRU; a growth rate above potential with a negative output gap; and record high equity market prices, implying easy financial conditions. Then you consider the current policy stances that you hold; Fed Funds at 1.50%, at least 125bps below your most recent estimate of the long term Funds rate and as much as 350bps below pre-financial crisis estimates, and a balance sheet that holds some $3+ trillion of bonds that you purchased via creation of excess reserves. Do you a) raise rates 25bps and continue to talk about gradualism going forward; b) raise rates 25bps and describe a faster pace of rate hikes as the economy steams forward; or c) raise rates 50bps since you finally have to admit you are behind the curve? Remember, your current policy stance was implemented as an “emergency measure” in the wake of the financial crisis and recession that followed…NINE YEARS AGO!

Now, clearly we have no idea where any of these data points will be come the day of the FOMC meeting, but the ones I have put forth are well within bounds, and would indicate an economy that has quite possibly left Goldilocks behind and is now on an official tear. Jay Powell is still an unknown quantity, but there is every indication that he is quite aware of the potential issues with allowing the economy to run too hot and watch inflation move rapidly higher, especially given the funding requirements of the US government as it adds to its deficits. What would you do? But more importantly, what can we expect the Fed to do?

The point I am trying to make is that when you lay out the current economic conditions, it is abundantly clear that US monetary policy is far too lax for the situation. I think it is pretty clear that the Fed understands this too, or at least most members do. But the real issue is if the data start to indicate inflation is rising even faster than currently anticipated, how long will it be before the Fed reacts more aggressively. Is it really that hard to accept they may choose to raise rates 50bps at a meeting? I mean, historically, it has happened many times in the past. Could that be the meaning of the addition of the word ‘further’ into the Fed statement? Could the Fed be signaling that the pace of tightening is going to increase going forward? Right now, only the Fed knows the answer to these questions, and I doubt they are clear. But these are not impossible outcomes. And I assure you that if the Fed becomes more aggressive; the dollar will find more support.

Now back to the markets. The President’s Day holiday saw relatively quiet trading elsewhere in the world, partly because much of Asia continues to celebrate the Lunar New Year, but also because the US markets weren’t around to add to the mix. As we walk in this morning, the euro has retreated more than 1% from its peak on Friday morning (-0.5% today) with other G10 currencies showing similar magnitude movements. What I am starting to sense is that the dollar is finding a broad bottom, and I don’t expect to see it decline sharply from these levels.

Specific news in G10 saw Swedish CPI disappoint (-0.9%, exp -0.7%), which has resulted in talk of the Riksbank continuing its ultra-easy monetary policy rather than beginning to tighten it on the back of solid economic growth. We also saw German ZEW Sentiment decline, but by slightly less than anticipated. In other words, the data from Europe was mixed, if sparse. There was a great deal of ink spilled regarding the yen, but none of it was policy related. Rather, there has been a significant increase in the discussion, as mentioned above, that the yen is set to replace the euro as the long currency position of choice. In fact, there was more discussion of market technicals as the rationale than any discussion of policy adjustments. That said, there are some who expect that the BOJ will begin to change its target on managing JGB yields, with a split between those looking for a higher cap, maybe 0.20% up from today’s 0.10%, and those looking for a change to targeting 5-year JGB yields rather than the current 10-year yield target. But those are analyst views with no input from anybody actually at the BOJ, so remain speculative.

In fact, this entire week is one with limited data releases although the FOMC Minutes are released tomorrow afternoon, and we do hear from seven Fed speakers across eight speeches during the week. Here is the entire list of releases of note:

Wednesday Existing Home Sales 5.65M
  FOMC Minutes  
Thursday Initial Claims 230K
  Leading Indicators 0.6%

This is hardly the stuff to generate excitement. So all eyes will be on the Minutes tomorrow afternoon, and ears will be tuned to the plethora of Fed speakers. My personal take is that things will sound more hawkish than the market expects and that we will see the 10-year Treasury touch 3.0% for the first time in more than 3 years. This is likely to put pressure on equity prices again (currently futures are pointing lower by 0.7%) and continue to help the dollar find a bottom.

Good luck