dollar rally

Fedspeak Boosts Dollar

May 19th, 2016 by

dollar rallyWith the markets paying close attention to signals from the Federal Reserve, per usual, the new narrative about where U.S. interest rates are expected to go—higher, sooner—has spurred a fresh rally for the dollar.

However, the prospect of the Fed raising rates back closer to normal could have a somewhat contradictory impact on the U.S. economy and global markets.

More Hawkish FOMC

Yesterday, the Federal Reserve Open Market Committee (FOMC) released the minutes from its April meeting. The minutes suggested an apparent bias by the committee in favor of raising interest rates at their June meeting unless economic data doesn’t improve at all.
Naturally, the markets gobbled up the news, as the dollar quickly jumped to a 7-week high. The USD was up again the following trading session, moving to 95.5 on the DXY index early Thursday morning.

yellen3This should of course all be taken with a grain of salt. We saw a similar “hawkish moment” from the Fed as recently as March. The central bank stirred up markets with talk of imminently raising rates. However, this hawkish rhetoric was swiftly followed up by a flood of Fedspeak, from Fed Chair Janet Yellen in particular, that dispelled the notion of a shift toward tighter monetary policy. In fact, Yellen even indicated the opposite—that more easing was on the table.

Will we see the same reversal and hedging back from this talk again from the Fed? It is certainly possible, considering the central bank’s penchant for influencing markets as it sees fit.

“End of Economics 101”?

The Fed raising rates (and therefore boosting the dollar) could have a divergent impact on world markets relative to the U.S. economy: it makes U.S. exports more expensive, weighing on overseas profits for U.S. companies. In response, equities fell to a 6-week low. At the same time, amid the global “currency wars,” places like Japan and the European Union would welcome a stronger dollar.

Yet central bank policy may well be entering the territory of becoming wholly ineffective. If you ask officials at Denmark’s central bank, the link between monetary policy and inflation is now weaker (or at least has become weaker in today’s world of NIRP) than was once thought. Lars Rohde, governor of the Danish central bank, says he thinks “it’s well-recognized that the marginal return on monetary policy has diminished.”

Indeed, as the chart above suggests, bond yields have steadily been falling in major economies like the U.S., Japan, and Germany over the past 25 years.

It’s also true that even as central banks have pursued more and more stimulus, the effect hasn’t been felt in terms of target inflation. At least, not yet. Could it crop up down the road? In any case, the confusion is making one thing clear: centrally planned economic policy ultimately doesn’t work.

What Next?

Source: MarketWatch

Source: MarketWatch

Some experts have recommended that seemingly impotent central banks who are battling deflation need to overshoot on inflation. For instance, Cecilia Skingsley, Deputy Governor or Sweden’s Riksbank, says that monetary policy of the future must be more “flexible” because the current framework is “not really as efficient as it was previously perceived to be.”

If this implies that the solution to ineffective stimulus is simply more stimulus, one wonders how that could possibly square with an interest rate hike from the Fed.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.

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