The Chairman explained to us all
Deflation is casting a pall
On future advances
While NIRP’s what enhances
Our prospects throughout the long haul
The bond market listened to Jay
And hammered the long end all day
The dollar was sold
While buyers of gold
Returned, with aplomb, to the fray
An announcement to begin the day; I will be taking my mandatory two-week leave starting on Monday, so the next poetry will be in your inbox on September 14th.
Ultimately, the market was completely correct to focus all their attention on Chairman Powell’s speech yesterday because he established a new set of ground rules as to how the Fed will behave going forward. By now, most of you are aware that the Fed will be targeting average inflation over time, meaning that they are happy to accept periods of higher than 2.0% inflation in order to make up for the last eight years of lower than 2.0% inflation.
In Mr. Powell’s own words, “…our new statement indicates that we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
You may have noticed that Powell adds no specificity to this new policy, with absolutely no definition of ‘some time’ nor what ‘moderately above’ means. But there was more for us, which many may have missed because it was a) subtle, and b) not directly about inflation.
“In addition, our revised statement says that our policy decision will be informed by our “assessments of the shortfalls of employment from its maximum level” rather than by “deviations from its maximum level” as in our previous statement.”
This is the rationale for their new willingness to let inflation run hot, the fact that the benefits of full employment outweigh those of stable prices. The lesson they learned from the aftermath of the GFC in 2008-9 was that declining unemployment did not lead to higher general inflation. Of course, they, along with many mainstream economists, attribute that to the breakdown of the Phillips curve relationship. But the Phillips curve was not about general inflation, rather it was about wage inflation. Phillips noted the relationship between falling unemployment and rising wages in the UK for the century from 1861-1957. In fact, Phillips never claimed there was a causality, that was done by Paul Samuelson later and Samuelson extended the idea from wage to general inflation. Eventually Milton Friedman created a theoretical underpinning for the claim unemployment and general inflation were inversely related.
Arguably, the question must be asked whether the labor market situation in the UK a century ago was really a valid model for the current US economy. As it turns out, the time of Downton Abbey may not be a viable analogy. Who would’ve thought that?
Regardless, Powell made it clear that with this new framework, the Fed has more flexibility to address what they perceive as any problems in the economy, and they will use that flexibility as they see fit. In the end, the market response was only to be expected.
Starting with the bond market, apparently, I wasn’t the only one who thought that owning a fixed income instrument yielding just 1.4% for 30 years when the Fed has explicitly stated they are going to seek to drive inflation above 2.0% for some time was a bad idea. The Treasury curve steepened sharply yesterday with the 10-year falling one point (yield higher by 6.5bps) while the 30-year fell more than three points and the yield jumped by more than 10 basis points. My sense is we will continue to see the back end of the Treasury curve sell off, arguably until the 30-year yields at least 2.0% and probably more. This morning the steepening is continuing, albeit at a bit slower pace.
As to the dollar, it took a while for traders to figure out what they should do. As soon as Powell started speaking, the euro jumped 0.75%, but about 5 minutes into the speech, it plummeted nearly 1.2% as traders were uncertain how to proceed. In the end, the euro recouped its losses slowly during the rest of the day, and has risen smartly overnight, up 0.7% as I type. In fact, this is a solid representation of the entire FX market. Essentially, FX traders and investors have parsed the Chairman’s words and decided that US monetary policy is going to remain uber easy for as far in the future as they can imagine. And if that is true, a weaker dollar is a natural response. So, today’s broad-based dollar decline should be no surprise. In fact, it makes no sense to try to explain specific currency movements as the dollar story is the clear driver.
However, that does not mean there is not another important story, this time in Japan.
Abe has ulcers
Who can blame him with Japan’s
Second wave rising?
PM Shinzo Abe has announced that he has ulcerative colitis and will be stepping down as PM after a record long run in the role. Initially, there was a great deal of excitement about his Abe-nomics plan to reflate the Japanese economy, but essentially, the only thing it accomplished was a weakening of the yen from 85.00 to 105.00 during the past eight years. Otherwise, inflation remains MIA and the economy remains highly regulated. The market reaction to the announcement was to buy yen, and it is higher by 1.15% this morning, although much of that is in response to the Fed. However, it does appear that one of the frontrunners for his replacement (former Defense Minister Shigeru Ishiba) has populist tendencies, which may result in risk aversion and a stronger yen.
As to the equity market, the Nikkei (-1.4%) did not appreciate the Abe news, but Shanghai (+1.6%) seemed to feel that a more dovish Fed was a net benefit, especially for all those Chinese companies with USD debt. Europe has been a little less positive (DAX -0.3%, CAC -0.1%) as there is now a growing concern that the euro will have much further to run. Remember, most Eurozone economies are far more reliant on exports than the US, and a strong euro will have definite repercussions across the continent. My forecast is that Madame Lagarde will be announcing the ECB’s policy framework review in the near future, perhaps as soon as their September meeting, and there will be an extremely dovish tone. As I have written before, the absolute last thing the ECB wants or needs is a strong euro. If they perceive that the Fed has just insured further dollar weakness, they will respond in kind.
Turning to the data, we see a plethora of numbers this morning. Personal Income (exp -0.2%), Personal Spending (1.6%) and Core PCE (1.2%) lead us off at 8:30. Then later, we see Chicago PMI (52.6) and Michigan Sentiment (72.8). The thing is, none of these matters for now. In fact, arguably, the only number that matters going forward is Core PCE. If it remains mired near its current levels, the dollar will continue to suffer as not only will there be no tightening, but it seems possible the Fed will look to do more to drive it higher. On the other hand, if it starts to climb, until it is over 2.0%, the Fed will be standing pat. And as we have seen, getting Core PCE above 2.0% is not something at which the Fed has had much success. For now, the dollar is likely to follow its recent path and soften further. At least until the ECB has its say!
Good luck, good weekend and stay safe