High Tide

The dollar continues to slide
But is risk approaching high tide?
Last night t’was the Kiwis
Who hinted that their ease
Of policy may soon subside

As well, from the Fed yesterday
Three speakers had two things to say
It soon may be time
To change paradigm
Inflation, though, ain’t here to stay

There will come a time in upcoming meetings, we’ll be at the point where we can begin to discuss scaling back the pace of asset purchases.”  So said, Fed Vice-Chairman Richard Clarida yesterday.  “We are talking about talking about tapering,” commented San Francisco Fed President Mary Daly in a CNBC interview yesterday.  And lastly, Chicago Fed President Charles Evans explained, “the recent increase in inflation does not appear to be the precursor of a persistent movement to undesirably high levels of inflation.  I have not seen anything yet to persuade me to change my full support of our accommodative stance for monetary policy or our forward guidance about the path for policy.”

The Fed’s onslaught of forward guidance continues at full speed as virtually every day at least two or three Fed speakers reiterate that policy is perfect for the current situation, but in a nod to the growing chorus of pundits about higher inflation, they are willing to indicate that there will come a time, at some uncertain point in the future, when it may be appropriate to consider rolling back their current policy initiatives.

But ask yourself this; if inflation is going to be transitory, that implies that the current policy settings are not a proximate cause of rising prices.  If that is the case, why discuss tapering?  After all, high growth and low inflation would seem to be exactly the outcome that a central bank wants to achieve, and according to their narrative, that is exactly what they have done.  Why change?

This is just one of the conundra that is attendant to the current Fed policy.  On the one hand, they claim that their policy is appropriate for the current circumstance and that they need to see substantial further progress toward their goals of maximum employment and average 2% inflation before considering changing that policy.  On the other hand, we have now heard from five separate FOMC members that a discussion about tapering asset purchases is coming, which implies that they are going to change their policy.  Allegedly, the Fed is not concerned with survey data, but want to see hard numbers showing they have achieved their goals before moving.  But those hard numbers aren’t here yet, so why discuss changing policy?

The cynical answer is that the Fed actually doesn’t focus on unemployment and inflation, but rather on the equity markets foremost and the bond market secondarily.  Consider, every time there has been a sharp dislocation lower in stocks, the Fed immediately cuts rates to try to support the S&P.  This has been the case since the Maestro himself, Alan Greenspan, responded to the 1987 stock market crash and has served to inflate numerous bubbles since then.

A more charitable explanation is that they have begun to realize that they are in an increasingly untenable position.  Since the GFC, the Fed has consistently been very slow to reduce policy accommodation when the opportunity arose and so the history shows that rates never regain their previous peak before the next recession comes along.  Recall, the peak in Fed funds since 2009 was just 2.50%, reached in December 2018 just before the Powell Pivot in the wake of a 20% drawdown in the S&P 500.  In fact, since 1980, every peak in Fed Funds has been lower than the previous one.  The outcome of this process is that the Fed will have very little room to cut rates to address the next recession, which is what led to QE in the first place and more importantly has served to reduce the Fed’s influence on the economy.  Arguably, then, a major reason the Fed is keen to normalize policy is to retain some importance in policymaking circles.  After all, if rates are permanently zero, what else can they do?

It is with this in mind that we turn our attention elsewhere in the world, specifically to New Zealand, where the RBNZ signaled that its Official Cash Rate (Fed funds equivalent) may begin to rise in mid-2022.  This is a full year before previous expectations and makes the RBNZ the 3rd G10 central bank to talk about tightening policy sooner than thought.  The Bank of Canada has already started to taper QE purchases and the BOE has explained they will be starting next year as well.  It should be no surprise that NZD (+1.15%) is the leading gainer in the FX market today, nor that kiwi bonds sold off sharply with 10-year yields rising 8bps.

Do not, however, mistake this for a universal change in policy paradigm, as not only is the Fed unwilling to commit to any changes, but the BOJ remains in stasis and the ECB, continues to protest against any idea that they will be tightening policy soon.  For instance, just this morning, ECB Executive Board Member and Bank of Italy President, Fabio Panetta, said, “Only a sustained increase in inflationary pressures, reflected in an upward trend in underlying inflation and bringing inflation and inflation expectations in line with our aim, could justify a reduction in our purchases.  But this is not what we projected in March.  And, since then, I have not seen changes in financing conditions or the economic outlook that would sift the inflation path upward.”

Investors and traders have been moving toward the view that the ECB would be tapering purchases before 2023 as evidenced by the rise in the euro as well as the rise in European sovereign yields.  But clearly, though there are some ECB members (Germany, the Netherlands) who would be very much in favor of that action, it is by no means a universal view.  Madame Lagarde will have her hands full trying to mediate this discussion.

For now, the situation remains that the central bank narrative is still the most important one for markets, and the fact that we are seeing a split amongst this august group is a key reason FX volatility remains under pressure.  The lack of an underlying theme to drive the dollar or any bloc of currencies in one direction or the other leaves price action beholden to short-term effects, large orders and the speculator community.  We need a new paradigm, or at least a reinvigoration of the old one to get real movement.

In the meantime, the dollar continues to drift lower as US yields continue to drift lower.  Right now, the bond market appears to have faith in the Fed narrative of transitory inflation, and as long as that is the case, then a weaker dollar and modestly higher stock prices are the likely outcome.

Today’s price action, NZD excepted, showed that to be the case, with APAC currencies performing well, but otherwise a mixed bag.  Equity markets are marginally higher and bond yields have largely fallen in Europe, although Treasuries are little changed after a 4bp decline yesterday.  Gold is actually the biggest winner lately, having traded back above $1900/oz as investors watch the slow destruction of fiat currency values.  But in the FX space, the USD-Treasury link remains the most important thing to watch.

Good luck and stay safe