Right, so one guy that’s contributing to Fed policy paralysis wears a furry, yellow animal on his head, spray paints his face orange (except for around the eyes), and talks only in superlatives.
See the thing is, the Fed is just f*cked. I mean can you imagine being in that position?
You’ve got this enormous balance sheet, you’ve got a vexing reflexivity problem wherein what you do affects the market but what the market does affects you, and now, you’ve got a President who, in addition to being completely unhinged, likes to play FX strategist in his spare time.
Then you’ve got that f*cking Peter Navarro, who exhibits this bizarre obsession with creating trade friction not just with China (I mean what do you expect from a guy who wrote a book called “Death By China” and then proceeded to make a movie about it complete with a blood soaked poster featuring a knife wrapped in a RMB100 note stabbing a star spangled continent) but with Germany and anyone else that exports anything other countries might want. When your BMW 7-series costs three quarters of a million dollars two years from now instead $145,000, you can thank Peter.
So if you’re Janet Yellen, how exactly are you supposed to hike against that backdrop? I mean just look at this chart:
That kind of suggests anyone who does anything to increase yield differentials (and thereby gives the dollar another excuse to rally) might well be taken out back of the Eccles building and shot. Figuratively speaking of course. Trump is taking an Erdogan-esque approach to the Fed, which is hilarious considering that this is the very same guy who not six months ago, chided Janet Yellen for not hiking rates.
So what are you supposed to do if you’re the FOMC and you want to normalize policy?
Well, you could try balance sheet reduction as an alternative tightening measure to actually hiking rates, because after all, it stands to reason that SOMA rolloff will affect the long end more than the short end, and the short end probably has more of an effect on the dollar, right?
You’d think so, but it turns out that’s wrong. Or at least it’s getting “less true.”
Here’s Citi with what we might call some “alternative facts” on the long end versus short end dollar dynamic.
Whilst Yellen’s Congressional testimony this week toned down expectations that the Fed will use its balance sheet as a monetary policy tool any time soon, we still think that the view that the $ will be relatively unaffected from any future balance sheet reductions is flawed.
We recently presented the regression analysis shown in Figure 1, showing Fed Funds (red line) vs. the difference in the rolling regression coefficient of the 2y rate differential and the 10y rate differential. A rising blue line suggests the short end is gaining in importance, a falling blue line suggests the long end is more of a driver.
Since 2014, the long end has been gaining in relative importance and what’s interesting is that recently the blue line went negative – suggesting the 10y rate differential is now the dominant driver.
As suggested by the chart, balance sheet sales and associated higher long end rates might even have a greater influence on the greenback than changes in the policy rates/short end.