Wednesday, June 13, 2018

Capital Markets: What's Up With the Buck?

I've been looking at charts of various price series for my entire adult life (actually, longer) and though not yet at the "Norman, the psychopathic AI" level I have to consciously remind  myself "Humans are pattern-recognizing machines and are so good at it that we can see patterns that don't even exist."

Take for example this chart of the dollar index (DXY):

I can't be the only person who sees Nessie (the Loch Ness Monster) can I?

Moving on, here's the head of Global Currency Strategy at Brown Brothers Harriman, Marc Chandler writing at his personal blog, Marc to Market:

Dollar Edges Higher Ahead of FOMC
The US dollar is trading firmly as the FOMC decision looms. In many ways, the actionable outcome of this meeting has hardly been in doubt this year. By all accounts, the Fed will deliver its second hike of the year today.

The question is not so much about the next meeting in August. The Fed has only hiked rates at meetings that a press conference follows. This is the source of one of our persistent criticisms of the pattern became obvious nearly as soon as the normalization cycle began in December 2015. We have advocated a press conference after every meeting, but not for the sake of transparency, and not simply because that is the bar set by the ECB and BOJ. We largely argued on operational grounds. It would maximize policymakers' degrees of freedom. Since Powell became Chair, there has been inside talk that this would be considered. The Wall Street Journal reported yesterday that this was indeed on the table.

The dollar traded higher when the news broke ostensibly on ideas that this would increase the scope for Fed hikes. But of course, the pace of Fed tightening is not really determined by the frequency of press conferences. We would suggest that the increased uncertainty of the timing of FOMC hikes is worth a bump in and of itself.

There are a few issues that are particularly salient. First and foremost is the number of hikes the Fed anticipates delivering. Although officials caution against coming up with a Fed view based on the summation of the individual member's views, investors have little choice. For the median forecast to move to four hikes this year (two in H2), only one member has to shift their vote. It is that close. Failing to do so would be seen by some as a dovish hike, though the Fed funds futures strip does not show the market is convinced of an accelerated pace.

Second is the pace of tightening next year. The median dot plot suggests three hikes will be appropriate next year. This is important in its own right but also regarding the yield curve. The Fed itself seems split, with most of the regional presidents appearing more concerned about the risks of an inversion of the yield curve than the Board of Governors. While the yield curve is understood to be a robust, forward-looking indicator, there are some factors that may be distorting it. For example, a large amount of negative yielding bonds coupled with the ECB and BOJ are still buying their bonds, there may be a "natural" demand for US Treasuries. The increase in the short-end may not simply be the result of Fed hikes. The Treasury's debt management has also favored the shorter end of the curve.

The third is what has become a fashionable argument: Given the large fiscal stimulus, the Fed should either slow down its hikes or slow the unwind of its balance sheet. That is to say, in the face of the fiscal stimulus the Fed should tighten less. This seems to turn economic logic on its head, though several distinguished people have put forth this argument. With fiscal stimulus hitting an economy that is already growing above trend and near full employment, tightening monetary policy seems quite orthodox, and not "financial suicide." Recall it is the policy mix of the Reagan-Volcker years and the policy mix that German pursued on reunification. That policy mix tends to be supportive of a currency....