Bernanke Bombshell Plus a Week

June 26, 2013

The impact on the dollar lingers even though the Fed’s provocatively hawkish message has been tempered by the subsequent comments of other Fed officials and by today’s revised first-quarter U.S. GDP estimates.  At this hour, precisely a week has elapsed since the FOMC statement was released.  On balance over this week, the dollar is holding on to net gains of between 1.8% and 2.6% against sterling, the yen, the loonie, the euro, the Swiss franc, and the Australian, Canadian, and New Zealand dollars.  The biggest mover among those dollar pairs has been the euro, and the smallest was sterling.  USD/CNY has a 6.14 handle versus 6.12 a week ago.

A stronger dollar exemplifies a risk-off environment and is consistent with other risk-off financial market swings over the past week.  The 10-year Treasury yield, which was as low as 1.66% on April 26, has risen from 2.20% to 2.56%.  The Dow Jones Industrials stock index has lost 2.6% of its value, and gold has plunged 10.5% and is on its way to its worst quarter in over 90 years.

The current dollar levels against the euro, yen, Swiss franc and sterling do not represent a departure from levels to which market players have become accustomed.  Put differently, the coming handoff from first half 2013 to the second half is not occurring with a big trend component in the dollar’s relationship to widely traded currencies of other industrialized economies. With midyear just two trading sessions away, the euro and sterling are merely 1.0% and 1.1% below their first-half averages against the dollar.  The franc, down 0.7% on the same comparison, is even closer to its first-half center of gravity.  Even the yen is but 2.2% below its first-half mean despite the Bank of Japan’s monumental policy change in early April.

The currencies of emerging markets and commodity-sensitive currencies have been sold more extensively than the above bunch.  India’s rupee hit a record low against the dollar today and has lost over 6% in June.  At today’s low, gold was 27.5% under its 2013 high and more than half of the way in falling from that level into sub-$1000 territory.  Gold drops out of favor when either the dollar is depreciating or when expected inflation is dropping.  The first possibility doesn’t appear to apply in the present case. 

The rise of long-term interest rates, on the on the other hand, contains an unwarranted element of uneasiness about future inflation even if the primal cause of rising rates is the confidence expressed by Bernanke in an economic forecast that will impel the Fed to begin reducing quantitative easing next quarter and to completely end that form of stimulus no later than a year from now.  Regarding future inflation risks, gold seems to be behaving more appropriately than nominal long-term interest rates.  Fear of inflation rests on theory that rapid growth in central bank asset holdings will generate an inflation problem.  Meantime, empirical evidence is mounting that disinflation is even more entrenched.  U.S. nominal GDP, which encompasses volume and price changes, went up at a 2.2% annualized rate in the first half of 2012.  That suggests that a neutral policy stance for a fully employed economy lies below 2.5%, and for a grossly underemployed one, the yield ought to be significantly less than 2.5%.  The 2.2% annualized rise of nominal GDP compares to growth of 4.3% annualized in the second half of 2012, 3.9% per year both over the last three years and the past ten years, 7.6% per annum in the last quadrant of the 20th century and 7.3% per year during the third quadrant of the century.

In describing plans to wind down quantitative easing, Bernanke was quite cavalier about the lowness of inflation and pitched his argument around unemployment more directly than the performance of GDP.  Today’s third and final estimate of GDP reveals greater weakness than the Fed has assumed, but the market is apt to act on the news only if forthcoming remarks by Bernanke or other Fed officials explicitly confirm that the data pose a potential problem for their exit strategy.  The data’s weakness is disconcerting not just for what it tells about the last quarter.  Real GDP of 1.6% over the past four quarters was less than in any of the prior three statement years.  Government spending has contracted by over 2.0% in each of the last three quarters, highlighting a more enduring drag than the sequester.  On-year export and import growth of 0.8% and minus 0.6% were each anemic, and non-residential business investment slowed to 3.7% in the year to 1Q13 from 12.5% in the prior statement year and 6.8% in the year to 1Q11.  The downward revision of consumer spending growth from 3.4% to 2.6% was the main driver of the downward revision to GDP.  The Fed’s strategy is based on projected growth centered on 3.25% in both 2014 and 2015.  Growth that robust has happened in just a single year since 2000, and 1999-2000 was the last duo of years to meet what monetary officials are assuming for 2014-15.  Finally, the personal consumption price deflator and core PCE deflator recorded substantially reduced rises of 1.2% and 1.3% over the past four reported quarters, down from 2.4% and 1.9% in the year to 1Q12.

The data are advising the Fed to abort its mission.  I doubt that will happen before late August.  In the meantime, the dollar ought to trade in a steady to firmer fashion.  The longer it takes the yen to reestablish a range on the weak side of 100/USD, the more uneasy investors will become about beating deflation in Japan.  It’s also good to bear in mind that summertime can be a breeding time for European currency crises.  Draghi pulled off a magic trick using illusion to quell turbulence last summer.  It would be ironic but plausible if the momentum of content with the euro swings the other way in the summer of 2013.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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