A Change is Gonna Come

March 25, 2015

World financial markets have lately been characterized by oscillating share prices, historically low long-term interest rates, a near record pace of dollar appreciation, and unthinkably cheap oil costs.  Forward-looking investors are trying to discern how these distinct themes will interact, which of the properties are most sustainable, and which seem less assured to continue because they are essentially derived from the other shifts. 

Considerable nervousness surrounds sentiment toward stocks.  An accelerating see-saw pattern oftentimes in the physical world precedes major changes and in financial trading can be a harbinger of a directional reversal.  The bull run over the past six years was driven by a QE-charged zero interest rate policy that is approaching a tipping point.  After rises amounting to 175% in the DJIA, 209% in the S&P 500, and 293% in the Nasdaq, one can only hope that this cycle doesn’t conform to the principle of the higher it rises, the harder it will fall. 

Long-term interest rates have defied a succession of theories explaining their level.  The direction has stayed downward even as Fed asset buying was tapered, ended, and been followed by signals preparing markets to expect a higher fed funds rate target soon.  A faster-than-expected jobless rate decline didn’t lift long-term rates, either.  Nor did Obamacare or the lessening Chinese appetite for U.S. Treasuries or softer growth in U.S. productivity, which averaged only 0.9% a year from 2012 through 2014. 

The dollar’s revival has been meteoric.  It advanced against the euro by 28.7% at an annualized rate over the nine months through March 16.  Such translates to a faster nine-month appreciation against the German mark than anytime since before 1990 including what came to be called the U.S. currency’s second golden age.  That’s when former Treasury Secretary repeatedly asserted “a strong dollar is in the best interest of the United States” because it reduces inflation, holds down long-term interest rates and promotes inflows of foreign capital.  One has to go back to the early 1980s to find a more compressed dollar advance against Europe’s dominant money than the latest episode.  In the nine months to July 8, 1981, for instance, the dollar soared 36.4%.  With U.S. monetary policy expected to tighten while the ECB and Bank of Japan pursue continuing quantitative stimulus, the case against further dollar appreciation appears weak.  Some forecasters now are predicting a euro near $0.9000, and a few wonder if the all-time high of $0.8228 in October 2000 will be revisited eventually.  If all this happens later this year, the euro’s maximum nine-month advance might top out closer to the aforementioned 36.4% than to 28.7%.

Opinion is widely diverse over whether oil prices are now finding an equilibrium a bit south of $50 per barrel or if the present is merely a pause in a downturn that will plumb lower into the $30-40 range.  The slump in oil has both supply-side and demand-side underpinnings, neither of which has yet unraveled.

The combination of cheap energy and a strengthening currency is highly desirable when exports and import-competing goods are competitive and inflation is elevated.  The soaring dollar in the early 1980s was associated with a plunge in U.S. consumer price inflation from 12.6% in September 1980 to 2.5% in July 1983.  However, U.S. inflation has hovered below target for a couple of years already, and the longer that continues, the greater becomes the likelihood of expected long-term inflation sliding, too.  Federal Reserve officials have to be very careful this time to ensure that inflation doesn’t drop significantly from present levels because of the rising dollar.  Even a dip into deflation caused by special factors at this stage of the business cycle would be extraordinarily difficult to reverse. 

Not all prices are equally important.  U.S. monetary officials have conspicuously avoided tying future policy on interest rates to the dollar’s performance, calling such just one of numerous factors that are being watched.  But no single price affects those for goods and services more than a country’s exchange rate.  It stands to reason, therefore, that how the dollar behaves in the future will in fact exert much more influence over monetary policy decisions than Fed officials care to admit.  Whether the initial interest rate hike is made in June, September, some time in between, or next autumn, a working assumption will be that the dollar’s very rapid rise of 34.5% annualized against the euro and 24.8% annualized against the yen since mid-2014 discounts future tightening and will therefore be largely completed by the time interest rates are actually raised.  Reconsideration would become imperative if instead the rising dollar gets a fresh tailwind after they lift the interest rate.

Changes are coming, and the dollar will not be insulated from them.  One should not think of the dollar, however, as just a dependent variable adjusting to all else that’s shifting.  The dollar is too influential for that, and its own response will create important feedback loops in the months ahead.

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



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