The dangers of a strong dollar and divergent monetary policy

This fall, oil prices have tumbled so quickly that the effect on inflation, monetary policy and the economy is likely to be dramatic. As yet, however, we don’t know what those effects are likely to be, in part because the economics profession does not have a well-formed view of how volatile energy prices effect core inflation measures. But I see the divergence in central bank stances resulting here as dangerous for markets. There are a lot of moving parts here and I will try to put them together below.

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This fall, oil prices have tumbled so quickly that the effect on inflation, monetary policy and the economy is likely to be dramatic. As yet, however, we don’t know what those effects are likely to be, in part because the economics profession does not have a well-formed view of how volatile energy prices effect core inflation measures. But I see the divergence in central bank stances resulting here as dangerous for markets. There are a lot of moving parts here and I will try to put them together below.

Let’s start with this from the Cleveland Fed:

A quick look at the year-over-year percent changes in the energy CPI and the CPI excluding energy suggests changes in energy prices are often followed by similar changes in the rest of the CPI’s components.

CPI less energy and CPI Energy IndexOn appearances, this appears to be an open and shut case of correlation that should mean lower core CPI at some point down the line. And judging from Mario Draghi’s recent statements, it would seem some central bankers are concerned about this. In the last ECB presser, Draghi made the following remarks:

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Now, let me make absolutely clear that we won’t tolerate prolonged deviations from price stability, and the main reason is that if these deviations feed into inflation expectations, they’ll cause a drop on medium to long-term inflation expectations, which by the way still are within a range consistent with medium-term price stability. But if these were to feed into inflation expectations, these lower outcomes of inflation, were to feed into lower inflation expectations, we would have a zero lower-bound nominal interest rate. This would be tantamount to an increase in the real interest rate. That is something to keep in mind. So it would be tantamount to an unwanted tightening of monetary policy. That’s why we are preparing ourselves in the way that’s been described in the introductory statement.

What I understand Draghi to be saying is that he believes the decline in oil prices could cause inflation expectations to decrease without a concomitant decrease in nominal long-term yields, making real yields higher across the curve. As the central bank controls only the short-term interest level, Draghi is concerned about anchoring inflation expectations because he believes this is the right way to give the ECB greater influence over the entire euro area yield curve. And if inflation expectations decline in his view, then real interest rates would go up. An oil price decline would thus lead to a rise in real interest rates.

I’m not buying this at all. Mario Dragh seems to assume that expected inflation is an independent variable when it’s not since long-run interest rates decline with inflation expectations. He makes it seem like the market believes the ECB will be at zero in the future no matter what. And so any downward movement in inflation expectations will mean an upward movement in real interest rates since the forward curve is predicated on zero rates from the ECB. That’s not the right way to look at it at all because the yield curve in Europe is flattening as inflation expectations decline. So real rates are not increasing.

But that doesn’t matter in terms of the ECB’s reaction function. What does matter is how much the ECB believes it must act to keep inflation expectations from falling. And to the degree Draghi’s comments represent the thinking behind future ECB policy, we should expect easing. In fact, we should expect QE, irrespective of what the Bundesbank wants. That’s bearish for the Euro and bullish for euro area sovereign debt.

But, in the US, it isn’t clear the same worry exists. Even the Cleveland Fed ends its piece writing:

With respect to inflation, the two most likely channels through which they could do so are retail gasoline prices and producer prices. However, as consumers use savings from lower energy prices for other goods and services, these prices are likely to rise in response, offsetting the initial disinflationary impact of lower oil prices. Accordingly, as the FOMC observed in its Statement on Longer-Run Goals and Monetary Policy Strategy, “the inflation rate over the longer run is primarily determined by monetary policy,” rather than by movements in individual price components.

The upshot here then from a monetary perspective is that it gives cover for ignoring the downward movement in the CPI Energy Index.

What should we expect to happen then?

Gavyn Davies argues forcefullythat the market is not reading the Fed’s willingness to raise rates well.

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In recent months, however, the markets may have become over confident about the Fed’s dovishness in the face of a large and persistent decline in the US unemployment rate. The forward interest rates now priced into the bond market are much lower than the FOMC’s “dots” chart, which shows the interest rate expectations of individual FOMC members. Even after the market’s upward adjustment in rates following Friday’s strong labour market data, that remains the case.

The “dots” will be updated at the next FOMC meeting on 16/17 December, and it is unlikely they will be revised downwards towards the market’s view. “Normalisation” is the new buzzword. Fed Vice Chairman Stanley Fischer made it clear in an interview with Jon Hilsenrath of the Wall Street Journal last week that he believes that interest rates are far below normal, even if inflation stays low. A further upward adjustment in market rates may become necessary soon, unless inflation greatly surprises the Fed on the downside.

The relationship between the forward rates and the “dots” published at the September FOMC meeting, is shown in graph below. The market’s forward path has, of course, been below the median “dot” for quite a while, partly because the controlling group on the FOMC, all close supporters of Chair Janet Yellen, are thought to be far more dovish than the committee as a whole. But the situation is fairly extreme, with the market’s path remaining more dovish than the 90th percentile of the FOMC’s range in its last meeting

If Gavyn is right, the pace of rate hikes in the US will be faster than the market anticipates. I think we are seeing the ECB and the Fed move in opposite directions here. And that is supportive of the US dollar bull market already underway.

But what about the equity bull market and the impact on other asset classes? First, let’s look at US equities.

Here’s an interesting perspective via Bloomberg. S&P 500 multiple expansion since October 2011 is 54% based on reported earnings, and 58% based on forward earnings. Multiples expand in a bull market, ostensibly because discount factors decrease and the increasing length of the economic cycle makes one dollar of earnings today worth more than it otherwise would be worth. The reality, of course, is that multiples expand because of herding and recency effects as people get more and more bullish in an economic cycle. A perfect example of this are statements from perma-bull Jeremy Siegel of Wharton. He says fair value on the S&P 500 is 2300, in large part because discount factors have decreased with “permanently” lower interest rates. Here’s Siegel:

I consider the fair value of the S&P 500 to be approximately 2,300. That is not necessarily a forecast for the end of this coming year, but I believe we are in a permanently lower interest rate environment, which supports higher than historical valuations for equities. I still believe P/E expansion is in the cards. An 18 to 20 P/E ratio is appropriate given what Bill Gross dubbed the “new neutral” interest rates that we are likely to see in the coming decade.

That’s interesting because I just told you the Fed may be raising rates in 2015. So the whole premise of his bullishness is undercut by this, then. And let’s remember that markets are supposed to be forward looking. The way I learned it in business school, it’s not today’s rates that matter. It is a normalized or averaged rate over the earnings life of the assets in question.

The reality is quite a bit different in terms of earnings as well. The EPS revision ratio, which is below one when earnings revisions are down, is now at 0.69 through November versus 1.11 in July. According to Gluskin Sheff’s David Rosenberg, the number hasn’t been this low since 2012 when QE3 was forced into action as a result. Energy names have been the leading culprit with the revision ratio at 0.20 in November, the lowest since April 2009, just after the cyclical bull market began. That number was 1.94 in June. Oil major BP’s announcement that it is cutting staff as the oil price declines tells you that more downward earnings are coming. But the earnings revisions are going down in consumer staples, industrials and materials as well.

Moreover, the downdraft in commodities and interest rates is more a signal of global economic weakness than it is of central bank policy rate expectations. Through last week, equities were up 12% and commodities down 9%, while the 30-year US Treasury was down 100 basis points, according to Mohamed El-Erian. That is a huge divergence that suggests these markets are sending different signals. For these markets to converge again, we will need to see commodity prices stabilize as a sign of growth or we will have to see equity prices fall as a sign of weakness.

But this is just the US. Globally, the concern that has to be building is the strong dollar that is the outgrowth of diverging macro policy. In Europe, Japan, China and elsewhere, economic weakness means continued policy accommodation. While in the US, signs of strength point to continued policy tightening. While the US domestic economy is insulated from economic weakness abroad, giving the Fed room to manoeuvre, the result is a strong dollar. And a strong dollar is the genesis of multiple financial crisis in the fiat currency period.

  • In the 1970s, soaring oil prices and the emergence of petrodollars meant lots of USD money went to Latin American government debt. Volcker’s high rate policy caused turmoil for these borrowers in the early 1980s as exchange rates collapsed and the Latin American debt crisis was born.
  • In 1985, at the Plaza Accord, major US trading partners agreed to weaken exchange rates against the dollar in order to help bring the US current account deficit down. But the strong Yen that developed as a result, took Japan into uncharted bubble territory that ended with a massive collapse in both shares and property values, neither of which have recovered 25 years later.
  • In December 1994, after the Mexican government devalued the Peso to stem a current account deficit and avoid a balance of payments crisis, the currency collapsed. Inflation had spiralled out of control and hyperinflation was a real risk. Hot money fled. A bailout and monetary and fiscal controls folowed, creating a depression as GDP collapsed by 6.2% in 1995 and the banking sector collapsed with it and was effectively bought out by US banks.
  • Later that decade, under Robert Rubin’s strong dollar policy we also got the Asian crisis, the Russian default, the Brazilian IMF bailout and Argentina’s default. All of these events were related to the strong dollar. In particular, think of Argentina’s currency peg and the impact that had on making the economy prohibitively expensive given the divergence in the macro conditions in Argentina from the US.

A strong dollar is toxic for emerging markets because those markets do not have deep capital markets, US dollar denominated debt a tempting option for governments and corporates alike. And this is what we are seeing yet again. Ambrose Evans-Pritchard writes:

Off-shore lending in US dollars has soared to $9 trillion and poses a growing risk to both emerging markets and the world’s financial stability, the Bank for International Settlements has warned. The Swiss-based global watchdog said dollar loans to Chinese banks and companies are rising at annual rate of 47pc. They have jumped to $1.1 trillion from almost nothing five years ago. Cross-border dollar credit has ballooned to $456bn in Brazil, and $381bn in Mexico. External debt has reached $715bn in Russia, mostly in dollars… BIS officials are worried that tightening by the US Federal Reserve will transmit a credit shock through East Asia and the emerging world, both by raising the cost of borrowing and by pushing up the dollar.

Does this have to end badly? No. But is the likelihood of volatility and crisis greater when macro policy divergence leads to strength in the world’s reserve currency? Absolutely.

Equities are expensive. They have tripled from 2009 lows and are trading at 16.2 times forward earnings, the highest level since July 2005, and significantly above the 15.3 level we had when Q4 began. And to the degree, the US can power forward despite the global growth slowdown, we should expect them to get more expensive. I see this as a problem, especially given the zero sum game that the world’s central banks are playing with beggar thy neighbour monetary policy. I don’t know how this ends but the fingers of instability are growing, and the potential for a crisis with them.

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