President Trump is caught in an insanity loop when it comes to the dollar. He is, it seems, at least somewhat aware of his plight.
Despite being cognizant of the fact that, in one way or another, his own policies and actions are responsible for persistent dollar strength, Trump refuses to relent on any front. The White House would have more fiscal stimulus if the administration could push it through, Trump refuses to deescalate the trade conflict which is exacerbating the economic disparity between the US and its trading partners, and, the cherry on the sundae, the president insists on boasting publicly about how well America is doing and how poorly other countries’ economies are holding up amid the worsening global slowdown.
Little wonder, then, that the dollar refuses to roll over, despite rampant expectations for additional Fed cuts and plunging US yields. The FOMC’s global counterparts have been forced to pivot dovish as their economies crack and crumble, keeping yield differentials “way too much” (to quote Trump) and thereby making USD assets seem enticing, even if hedging costs are punitive.
Worse for Trump is the fact that, depending on the circumstances, the dollar has a lot of haven appeal, and it’s generally been buoyant during episodes of escalating trade tensions.
As noted earlier this week, history suggests that the only way the dollar can weaken in an environment when the US economy is outperforming is for the Fed the cut rates faster than its peers, which is precisely what the president has spent the last four months demanding on Twitter.
The cruel irony, of course, is that the very same relative economic strength that’s helping to keep the greenback buoyant makes it all but impossible for the Fed to justify the kind of aggressive rate cuts that would count as “relatively” dovish compared to the ECB, the RBA, RBNZ and on and on. But, without aggressive cuts, the Fed risks importing deflation, and thereby a further undershoot of the price target.
So, if you’re looking for reasons why the market is pricing a full-on easing cycle from the Fed, you might think about it through that lens, rather than through the lens of a recession. That is, it might not be that the market sees something the Fed doesn’t in the data, “it could be that the market is associating a full easing cycle with a somewhat different scenario or set of scenarios that ultimately require much lower short rates”, Deutsche Bank’s Stuart Sparks writes, in a Friday note hitting on a number of the points mentioned above.
The issue, Sparks says, isn’t just the possibility of a US recession. Rather, the issue is that “there is a third scenario whereby short rates might need to fall substantially even if there is not a US recession”.
The contours of that scenario were fleshed out above, and Deutsche fills in the details. “If the rest of the world is easing, then on the margin the Fed must ease more in order to short circuit dollar appreciation that would put further downward pressure on domestic inflation, when core PCE inflation has already slipped non-trivially relative to target”, Sparks goes on to say, adding that although the dollar initially weakened with a decline in a terminal rate proxy, the greenback quickly snapped back on further confirmation of imminent ECB action. More alarming, the dollar has moved higher despite another 40bp leg lower in the imputed terminal rate.
That, frankly, is trouble. As Sparks puts it, “the implication is that the Fed must run faster to stand still”.
If nothing is done to ameliorate this situation (and assuming the external environment stays on its current course defined by slowing ex-US growth and dovish monetary policy in other locales) things could get particularly dicey or, as Sparks says, “there is a problem here that begins to smack of inevitability”.
Imagine, for instance, that the US economy continues to outperform while the rest of the world remains mired in, at the least, a manufacturing slump. In that scenario (which seems like the most likely course in the medium-term) another rate cut or two from the Fed without any indication that Powell is prepared to do something more dramatic if the market tests him, would probably be wholly insufficient to ease the upward pressure on the dollar.
“If the price Phillips curve remains very flat, then running the economy hot might increase growth differentials but fail to generate enough domestic inflation to offset the tendency of a strong dollar to import disinflation”, Deutsche’s Sparks posits, before rounding things out by noting that if, under those circumstances, “growth in the US converges downward toward the external environment, then the Fed will rapidly have to catch up in the race to ease to head off the problems of a more conventional recession”.
What’s particularly amusing about the above is that although Trump couldn’t articulate the issue in anything that even approximates the kind of precision employed by a Wall Street rates strategist, the president has seemingly cobbled together a similar narrative inside what he variously describes as his “very large brain”, and he isn’t enamored with what little he’s been able to infer about the likely ramifications for the economy, and thereby the election.
As far as what’s coming down the pike directly, Powell has a chance to “correct” his latest “mistake” by somehow walking back the “mid-cycle adjustment” characterization in Jackson Hole later this month.
“If he does not do so, we would expect another round of Fed disappointment to be the catalyst for 10y yields to fall even further”, Deutsche Bank says, adding that “in that environment, dollar appreciation in spite of more aggressive pricing for Fed easing, lower breakevens, and additional downward pressure on the term premium could propel Treasury yields to new lows”.