The Dollar, Fed Policy and Falling Equities and Commodities

July 27, 2015

One possible explanation for the stalled dollar advance was offered in last week’s Foreign Exchange Insights essay, namely contrasting current account positions in the United States on the one hand and the eurozone and Japan on the other.  This week scopes out three other factors that may limit the U.S. currency’s strength.

The first factor concerns Fed policy.  It now seems that U.S. data during this summer and autumn will not be the prime determinant for the timing of the first or even second increase in the federal funds rate.   The data for some time have been passable, but far from stellar, from the standpoint of assuring quick progress toward full employment and a rise of inflation back to the 2.0% target. 

An abrupt slowdown in the U.S. growth trendline at the beginning of the current century has not reversed and is not likely to do so, either.  This reveals a fundamentally weaker bang in productivity growth from mobile and cloud computing than occurred from the earlier development of personal commuters, which had spurred the economy in the 1990s.  Real GDP in the fifteen years from 4Q99 to 4Q14 grew on average by 1.9% annually.  In contrast, real GDP growth averaged 3.7% a year over the second half of the twentieth century between 4Q49 and 4Q99.  Bisecting that very long span of time shows average growth of 3.4% per annum during the last quarter of the century, which was not particularly slower than had been seen between end-1949 and end-1974.  In a telling document released last week of Federal Reserve Board staff projections, real GDP is projected to rise by 1.9% per year between end-2014 and end-2020, the same pace as between end-2008 and end-2014.  In none of the projected six years was projected GDP above 2.5%, and in none is the unemployment rate shown dipping below 5.0%.  Inflation, measured by the personal consumption price deflator is forecast to average 1.6% per year in 2015-20 and doesn’t quite get above the 2.0% target even by end-2020.  The core PCE deflator and expected long-term inflation are each forecast to climb 1.8% per year from end-2014 to end-2020, also somewhat below target. 

The message that what’s been observed in the post-Great Recession recovery is as good as things are going to get is reinforced in the Fed staff’s assumed rate of growth in non-inflationary potential GDP growth which averages merely 1.7% per annum in the six years from end-2014 to end-2020.  For Fed officials to wait for faster growth before normalizing policy would be the proverbial wait for Godot.  Officials from Chair Yellen downward have consistently guided investors and the public into expecting one or two rate hikes during the remainder of this year, a message that wasn’t dumbed down when the Greek crisis turned ugly or now as China’s slowdown is affecting financial markets all over the world.  One is left to infer that an intensified sense of urgency lies behind the desire to start rate normalization without further delay, and this probably means that Fed officials attach greater weight to the costs to financial market functionality of keeping interest rates for longer at zero than to damage of raising rates before the economy is quite ready to handle that change.   And while officials have stressed that the tightening cycle will not be a measured one like the previous one, the above document shows that Board staffers nonetheless expect similar year-end to year-end increases in the nominal federal funds rate of 91 basis points in 2016, 86 bps in 2017 and 68 bps in 2018. 

One can imagine that investors might be a bit unsettled by denials of a policy transition marketed as one that will be guided by unfolding data and Board staff forecasts that seem to conform to a pre-determined timetable.  The relationship between the dollar and Fed policy most closely fits investors’ sense of the policy’s appropriateness.  If the coming cycle is of rate increases appears more similar to the framework that defined the 2004-06 cycle, it would give investors pause for thought because the last one, viewed with insight, seems to have promoted the buildup of asset price bubbles, and that might be holding the dollar back.

The recent drop in U.S. stock prices amounts to only around 5%, well below the 10% threshold for a correction or the 20% yardstick that is widely considered a bear market.  Based on lapse of time, a correction seems widely overdue, and even a bear market would not be shocking.  A check of the dollar’s performance from the start of eight previous large declines in U.S. equities to three months past when those slides hit bottom shows a dollar decline six times against the mark and/or euro and seven times relative to the yen.  Weak U.S. equities more times than not blunt dollar strength.

  • A 36.1% drop of the DOW in August-October 1987 was associated with dollar losses of 7.5% against the mark and 9.2% against the yen.
  • A 21.2% drop of the DJIA in July-October 1990 saw the dollar fall 7.5% against the mark and 10.0% versus the yen.
  • When the DJIA fell 16.4% in early 2000, the dollar rose 6.7% against the euro and dipped just 0.3% against the yen.
  • A 27.4% slide of the DOW in 2001 was associated with a 1.7% dip of the euro and a 5.1% rise against the yen.
  • In 2002, a 31.5% fall in equities was associated with dollar tumbles of 15.8% against the euro and 9.1% versus the yen.
  • From October 2007 to March 2009, the DOW plunged 53.8%.  The euro edged down 0.2%, but the dollar plummeted 16.9% against the yen, which performs generally well in extreme risk-off conditions.
  • A 16.4% fall of the DJIA in 2010 corresponded to lagged dollar losses of 3.4% against the euro and 11.6% versus the yen.
  • A a 16.8% drop in U.S. equities in 2011 saw the dollar soar 13.9% against the euro but fall by 5.7% against the yen.

An argument is circulating that the dollar’s leeway for appreciation against the euro has been squeezed by the price decline in oil, other commodities, and commodity-sensitive currencies.  I’d be a little skeptical about such logic.  In the late 1990s during the Asian crisis and the heyday of the Rubin “strong dollar is in the best interest of the United States” period, West Texas Intermediate oil fell from a monthly average of $21.31 per barrel in October 1997 to $10.87 on average in December 1998.  A big-time oil bear market was juxtaposed against a large bull market for the dollar.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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