Wildly Exciting Times for Currency Market Observers

March 19, 2015

Currency movements matter immensely but rarely get proper respect in U.S. macroeconomic policy.  In the unraveling days of the post-World War 2 fixed exchange rate era, former Secretary of Treasury John Connally arrogantly told his Group of Ten counterparts that the dollar is our currency but your problem.  These days, in contrast, the sharply rising dollar commands everyone’s attention including members of the Federal Reserve Open Market Committee. 

Dollar appreciation has been powered primarily by two factors.  Tumbling oil prices initially created more economic havoc than benefit, pushing many countries to the brink or into deflation, but that is a much lesser risk for the United States than for Europe, Japan, or a slew of developing economies.  The second force supporting the dollar is very polarized monetary policy stances.  Hardly a day passes without a central bank tightening or loosening its stance or, if not that, surprising analysts by committing or omitting an action that was anticipated.  In March alone, main central bank interest rates were lifted 550 basis points in Ukraine and 50 bps in Brazil but cut 100 bps in Russia and to a lesser extent in China, India, Poland, Thailand, South Korea.  Sweden moved more deeply into negative interest rates, which can also be found in the eurozone, Denmark, Czech Republic and Switzerland.  The European Central Bank began quantitative easing (QE), while the Bank of Japan failed to augment its QE in spite of disappointing growth and a relapse of inflation to roughly zero. 

The buzz words in Fed policy is that interest rate increases will be data driven and the progress that trends make toward meeting two subjectively defined criteria dealing with the labor market and inflation.  Prior to 1994 when changes in Federal Reserve policy weren’t even reported when done, good Fed watching required highly refined skills.  The push for transparency took a lot of the fun away from the game, but now it seems that without throwing transparency away that the old skills will be again required. 

Not every interest rate hike is the same.  Those done recently, for instance, by Ukraine and Brazil, were intended to counter inflation and currency vulnerability.  When the time comes for the Federal Reserve to raise interest rates, it will on the surface be a sign of perceived relative strength.  The operative word there is “relative.”  U.S. GDP has expanded faster than the growth of most other large developed economies, but the U.S. performance is not good in the context of U.S. historical norms.  For all the hoopla about improvement, U.S. real GDP growth in 2014 of 2.4% was hardly different from that of 2.2% in 2013 or 2.3% in 2012.  It used to be that 3.0% growth divided a good year from the rest, and only 3.8% in 2004 and 3.3% in 2005 met that criterion among the past fourteen calendar years.  And while the first derivative of U.S. economic activity is hovering above 2.0%, the second derivative really reveal very scant acceleration in that growth.  Digging even deeper, one finds little grounds for great confidence in nonfarm labor productivity, which posted sequential low and declining rises of 1.0% in 2012, 0.9% in 2013, and 0.7% in 2014.  In the late 1990s golden age of the dollar, an explosion of U.S. productivity caused by beneficial applications of computer power made the rising dollar seems fundamentally right and harmless to the U.S. economy.  In the other golden dollar era, the steep decline from double digit inflation back to historical norms did the same.  There isn’t a U.S.-centric reason why it is appropriate and safe for the dollar to be climbing so steeply.

An additional challenge for those trying to fathom what the dollar will do next is the great amount of noise found in market data.  It’s bad enough that just when U.S. monetary policy is moving to a higher level of alert for launching rate increases that only labor market data are performing as well as hoped.  At the same time, stocks and bonds are swinging unnaturally widely.  If the Dow Jones Industrial Average falls over 100 points today, it would be the sixth such drop of the month to go along with five daily rises of over 100 points and just three sessions that saw a move of less than 100 points.  The big moves have not evolved in runs as one might imagine but rather in ping-pong fashion, jumping one day, plunging the next, and rebounding again on a third.  In fixed incomes, 10-year sovereign debt yields have fallen in the past week by 10-20 basis points in the U.S., U.K., Canada, and Australia and from 0.25% to an incredibly low 0.18% in Germany. WTI crude oil has declined over 10% since March 11. 

Such volatility dwarfs the information upon which it is feeding and underscores that when the Fed starts raising interest rates instead of considering such as now, it will be a true leap into unchartered waters of unknown depth.  The ECB and Bank of Japan in recent years had regrettable experiences after unwisely attempting to normalize interest rates.  The market reaction to Fed tightening in 1994 caused U.S. growth to slow very sharply in early 1995, and premature tightening in 1937 led to the deep recession within the Great Depression.  Knowing this history, top Fed officials will be watching the U.S. economy’s response on all imaginable levels especially the dollar when it acts and hoping that it is indeed possible to get there from here, meaning to an eventual appropriate long-run level for the federal funds rate that FOMC members according to the latest dot plot believe to be 3.5-3.75%.  I suspect equilibrium will prove considerably lower.

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



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