The Dollar Post-Fed Pivot (And Other Musings)

I guess I don’t have to say this, but the dollar is poised to be a hot topic going forward.

I’ve variously suggested the June FOMC wasn’t in itself a “momentous” game-changer, but I’m apparently in the minority on that view. In fact, I was starting to think I might be totally alone in that assessment, and while isolation certainly isn’t new to me, I’ll confess I was relieved when TD’s Priya Misra said, on Friday, that in her view, “the hawkish shift was more a function of the Fed’s risk management approach rather than a monumental shift in the reaction function.”

That said, I do think the hawkish tilt was material (if not necessarily “monumental” or “momentous”) for the dollar, which is coming off its best week since the crisis began (figure below).

If you look at an intraday chart from Friday, the dollar’s reaction to Jim Bullard’s comments (and concurrent cross-asset moves) underscored just how meaningful it is for the greenback that the Fed is now perceived as being out of hibernation (or “not asleep at the wheel,” as David Tepper put it).

“For currencies, plainly the immediate mix of both an adjustment in short-term US rate expectations and a back-end move dominated by a rise in real rates as breakevens declined, is the perfect positive USD storm,” Deutsche Bank’s Alan Ruskin said, in a note called “Humility.”

Bloomberg’s Kriti Gupta noted that “if this is indeed the end of the greenback’s downtrend, the repercussions will be widespread from commodities to emerging markets and even to stocks.” The “pros” among you might call that stating the obvious, but sometimes the obvious needs stating. And, at the risk of pounding the table too hard, the importance of the dollar-real yields nexus and the potential ramifications for risk assets can’t be overstated — no matter how “obvious” such statements might be.

“The dollar index has broken above its 200-day average, and it’s been tracking a weighted average rate differential pretty well this year,” SocGen’s Kit Juckes remarked, referencing the visual below.

“DXY almost made it back to the early January lows earlier this month, but relative five-year rates have now surely bottomed and it’s going to be difficult for DFXY, at least, to make new lows now,” Juckes added.

Deutsche’s Ruskin offered a pretty incisive take on the Fed’s apparent self-reflection.

“Unlike after the 2008/2009 GFC, the maximalist dovish Fed has been forced to shift toward market expectations on policy, rather than the market shift toward the Fed,” he said. “This may be rare, but somewhere in there is an acknowledgment that the market might for now be doing a better job at forecasting the Fed than the Fed at forecasting the Fed.”

I suppose I’d note that determining who’s leading who when it comes to markets and the Fed is getting more difficult all the time. The market can effectively dictate Fed policy by leaning so far in one direction that refusing to at least nod in the same direction chances destabilizing things. If the market wants a rate cut, for example, and that gets priced in, a stubbornly hawkish Fed in the face of one-sided positioning risks a tightening of financial conditions, which, in turn, may end up compelling the very same dovish lean policymakers were trying to avoid.

You might say the same thing, only in reverse, as it relates to the current dynamic, wherein the Fed was seemingly determined to remain dovish despite rising inflation, but it doesn’t seem as though the market was prepared for the dot plot shift. So, in this case, it’s the data that’s dictating the shift more than any market pricing. “The changes to the CPI trajectory were so large that CPI out-dueled labor market indicators within the Fed’s dual mandate,” Ruskin said. He also noted that in the immediate aftermath of the June FOMC, implied fed funds betrayed only “very modest moves for a supposed sea change.”

Of course, there’s a theoretical limit on how far forward the market can pull rate hikes given that tapering has to be executed first. But, for Ruskin, there’s now a risk that the taper announcement gets pulled forward to September (from consensus December).

“Even the Fed’s own economic forecasts are inconsistent with their rates views,” Ruskin remarked, noting that if you “plug in the numbers” from the SEP to the Taylor Rule, “policy is the easiest in the last four decades, and that would not change much by the end of 2022, if the Fed funds rate forecast is correct.”

It’s not terribly difficult to imagine the Fed getting consumed by this debate (indeed, that was their job before they took up the mantle of social justice) on the way to getting more aggressive about things. At the same time, it’s also not hard to posit a scenario where additional nods to “early” tightening catalyze too much dollar strength and an untenably rapid rise in real yields, in which case policymakers could be forced to retreat in the other direction.

Note what’s missing from both of those prospective outcomes: Any mention of the social justice mandate that was implicitly adopted alongside average inflation targeting nearly a year ago.