dollar FX Markets

‘There’s A Problem Here That Smacks Of Inevitability’: Recession Or No, The Fed Has To Cut Rates Aggressively

If you're looking for reasons why the market is pricing a full-on easing cycle from the Fed, try this lens.

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.

(Deutsche Bank)

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”.


 

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10 comments on “‘There’s A Problem Here That Smacks Of Inevitability’: Recession Or No, The Fed Has To Cut Rates Aggressively

  1. gas jockey

    Whoa there, it seems that one big reason rates are screaming in a crash-like fashion, is because there is a huge amount of risk out there, not unlike 2005 or so. Rates crash when people want super liquidity and want short-term securities. At this point, rate cuts are pointless, because the cat is very obviously out if the bag looking at the genie who’s also outside the bottle, and cat and genie are both wondering how to put perfume molecules back into the broken bottle. A rate cut will not stimulate the economy or save it or make trump look like a genius. We saw what happened with massive quantitative easing, after rates crashed, and, as you may recall, it took about 10 years to re-set the punch bowl and re-start the party. The main problem the Fed had last year, was to believe they had to build-up rates and prepare for a future recession, and while they were totally focused on that micro objective, they misread the macro data and should have cut last year. The Fed has basically covered the ground with jet fuel and trump flings matches.

  2. Anonymous

    Amazing how things have changed. This would never have been even thought of before. And if so, no on would have ever mentioned it least be laughed out of the business. The scares of the GFC remain. Thank you Bernanke for leaving us this legacy.

  3. Harvey Cotton

    The fed fund rate is 2.25%. At the end of the longest economic expansion in American history, with the unemployment figure at a decades low rate, with the stock market about 5% from record highs.

    2.25%.

    And this is too tight, because it is higher than in Japan and Europe. So the Fed cuts. You know what will happen after the Fed cuts? It will still be higher than Japan and Europe. I promise. You know why? Because the rates in Japan and Europe are negative. And the ECB and BoJ still have room to cut.

    So should the Fed cut, what, 350 basis points? 500? To prevent “disinflation?” Because the economy, in this, the “good times” has obviously made the people very happy. You can tell by our politics. Left-wingers and right-wingers are united in joy in what the gig economy has wrought with flat wages, debt, and unaffordable university and medical costs. Life expectancy is going down, in this, the wealthiest country in the history of the world. Most Americans cannot cover an emergency $400 expense out of pocket. Half of all Americans have precisely $0 saved for retirement. Many people have so little faith and credit in their money that they would rather swap them out in their thousands to gamble on inherently worthless digital tokens.

    And the remedy for this, is to tempt inflation because what people who have no exposure to the stock market and have negative wealth need is higher prices. Maybe that will spur them to invest in risk assets…

    And this advice comes from Deutsche Bank? A criminal organization that is on the verge of bankruptcy?

    Anyway, we have tried this. Rates were kept at 0% for a decade, and it resulted in the weakest economic expansion ever. They have tried this in Japan and Europe for decades. It is not working. It will not work at 1.75%. It will not work at (1.75%). We have to recognize that maybe the gangster institutions that launder money for drug lords, terrorists, and mafiosi may not have the public interest in mind. Maybe they want lower transaction costs for themselves and access to cheap money to keep their racketeering operations afloat.

    • Lance Manly

      The whole thing about importing deflation is a bit overblown. Look at the CPI, what is holding it up services, shelter, medical… not goods. Not that tumbling goods won’t effect it, sure it will. But the Phillips curve appears to be still breathing in services and that still might bite the Fed https://www.youtube.com/watch?v=jYcPBE5PXhs

      • thunderhead

        CPI is a pointless exercise in stupidity, take a look a the methodology behind that farce, e.g. learn about Homescan; there are many reports on how flawed that data is and the method used to collect noise:

        We focus on recording errors in prices, which are more prevalent, and show that they can be classified to two categories, one due to standard recording errors, while the other due to the way Nielsen constructs the price data. We then show how the validation data can be used to correct the impact of recording errors on estimates obtained from Nielsen Homescan data. We use a simple application to illustrate the impact of recording errors as well as the ability to correct for these errors. The application suggests that while recording errors are clearly present, and potentially impact results, corrections, like the one we employ, can be adopted by users of Homescan data to investigate the robustness of their results.

        https://www.nber.org/papers/w14436

  4. A bad deal is a bad deal no matter how cheap the money. Taking pressure off debtors will help but stop expecting rate cuts to do things they never were particularly adept at doing. The Fed can strengthen the floor. Raise the ceiling? Not so much.

  5. I am trying to think of a previous time the Fed has been forced into cuts or raises by other countries’ actions. Is that common, rare, very rare?

  6. After reading the first six comments here I also tend to strongly disagree with the Message in the title of this post… This is all about a small affected minority trying to save their collective butts and avoid a “pay back reaction ” for the excesses of the past decade in a cascade of illiquidity that is inevitable.. This salvage attempt is not in the name of the people (so to say) as a bulk are bystanders to the goings on in the last cycle. All the manipulating has already be done to try to engineer a happy “Goldilocks ” outcome the system so desires to maintain the status quo of the power base. I doubt the result of a reset will be as catastrophic as has often been predicted by many…except to the most beneficially effected and unfortunately the most vulnerable whom coincidentally are not the ones thriving in the present status quo.
    Unfortunately , I see few alternatives to avoid all this and maybe that is what is driving all the rhetoric…

    • “…in anything that even approximates the kind of precision employed by a Wall Street rates strategists…”

      All I really have to say on the big financial data haruspicy is that it is indeed the finest information proctology that can be bought – but one bankster’s metric of Oracle is another analyst’s stochastic Cassandra. The dollar was at a decades abyss during the dot com crash but at an apex during the Great Bush Recession crash.

      History and the future are mismatched co-dependents, often….

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