More on king dollar and EM (and shale producer) vulnerability
Last week the Fed admitted to having mistakenly made public forecasts by staff economists which suggested that the Fed is indeed on a 2015 rate hike path. As a result, policy divergence is now set to widen, with the result being a bid for the US dollar and a decline in commodities priced in US dollars. Coupled with the ongoing slowdown in China, this is bad news for shale oil producers and emerging markets. My analysis follows below.
The first piece of the puzzle that I find interesting is the degree to which the Fed economists have determined that the output gap is minimal and that productivity growth will be weak. From a supply side perspective, the Fed is basically saying there remains little to be done. It is as if they have come to see the long-term unemployment problem and the weak labor participation rates as intractable problems beyond the scope of monetary policy.
The capitulation of the Fed on the supply side then paves the way for rate hikes, given the benign top-line macro data – GDP growth, personal consumption, jobless claims, and non-farm payrolls. The Fed is projecting 0.35% for the Fed Funds at the end of the year if the data environment pans out as expected. The Fed believes this is still an accommodative stance, however. And to the degree the US economy’s top-line macro numbers outperform – I’m not talking about wage growth or labor participation here – rate hikes in 2016 could be in the offing as well. The bottom line, then, is that the baseline Fed policy stance is one with what I would call policy divergence tail risk, meaning that there is a non-zero probability that divergence between the US Federal Reserve and other policy makers increases over time.
Markets are beginning to understand these facts, such that policy divergence has bolstered the US dollar. We see the US dollar strong versus the euro, the Japanese yen and the whole dollar complex. The US dollar is also strong against all industrial commodities, oil and precious metals. Irrespective of how well the EM economies are doing, this is a headwind. But the EM economies are doing badly – China and Brazil in particular. So we have a situation where EM vulnerability has increased and the potential for another EM crisis has also increased.
At the same time, the whole shale oil shake out is not finished by a long shot. All of the problems we aw in late 2014 with regard to souring loans, a spike in energy high yield bond yields, and a cut in capital investment will come back to that market. To the degree this slows US growth, it will be stabilizing to the ability of divergence to create more market pressure because this would slow the pace of rate hikes. But I expect market fallout to begin later this year or early next year with bankruptcies in the shale oil sector. And we will just have to see how pronounced the impact is.
The US economy is in relatively good shape right now. Outside of Greece, the European economy is also doing reasonably well too. But policy divergence and a slowing in China are headwinds that will keep the global economy stuck in a lower gear for some time to come.