The Outlook for Central Bank Policies and the U.S. Dollar

24 Aug 2016

Key takeaways

  • The Federal Reserve (the Fed) has been warning markets about a normalization of interest rates since the “taper tantrum” of May 2013.
  • The U.S. Dollar Index (DXY) rallied by 15% from two years ago, as a result of expectations of a significant and protracted monetary policy divergence between the U.S. and other major central banks, especially the European Central Bank (ECB) and the Bank of Japan (BOJ).
  • There has been only one Fed hike of 25 bps to date, and bond market yield spreads have only moved by 35 bps since two years ago vs. Germany and Japan.
  • In the last few months, the Fed’s longer-term expectations about the U.S. economy and the terminal funds rate have been falling sharply, while the negative yields in Europe and Japan are limiting the outlook for further monetary policy divergence.

Full commentary

The Fed has been warning markets about a normalization of interest rates since the “taper tantrum” of May 2013, when Chairman Bernanke first brought up the topic of tapering quantitative easing (QE), leading to great volatility that summer. Since then the Fed has ended QE, and after more than a year of predicting a “lift-off” of rates from zero, the Fed finally raised the funds rate once by 25 bps in December 2015. As we entered 2016, the Fed Vice-Chairman, Stanley Fischer, confidently predicted four hikes of 25 bps for this year. By mid-year, the Fed’s forecast had been reduced to two hikes. A number of key Fed officials are trying to convince markets that there may be a hike this year, while markets give less than even odds to a hike by March 2017 and only fully price one hike by early 2018. As we approach the Jackson Hole conference of August 26th, where the symposium topic is “Designing Resilient Monetary Policy Frameworks for the Future,” it is an opportune time to reassess the outlook for Fed policy and the U.S. dollar.

The U.S. dollar rallied by 15% vs. the euro, and the U.S. Dollar Index (DXY) had a similar move, since exactly two years ago, as a result of expectations of a significant and protracted monetary policy, divergence between the U.S. and other major central banks, especially the ECB and the BOJ. In retrospect, there was a single 25 bps tightening in these two years while government bond yield spreads in the five year sector moved in favor of the U.S. by about 35 bps vs. both Germany and Japan, where these yields are now well into negative territory.

In the last few months, the Fed’s longer-term expectations appeared to be changing. There is a nascent feeling among key members that the long-run equilibrium rate is much lower than the 3.5-4% level first discussed before liftoff last year. This is the result of persistent disappointment at the economy’s performance: productivity and therefore potential gross domestic product (GDP) growth appears lower than anticipated. Similarly, improvements in the labor market have not generated inflation pressures yet, suggesting monetary conditions remain tighter than anticipated. The Fed’s “Phillips curve” monetary policy framework of ensuring that the funds rate reaches its equilibrium level when inflation reaches its 2% target, has become less certain. While the plan was to be preemptive in raising rates as the unemployment rate falls, many now argue that it is less clear that there is much urgency until inflation actually starts to increase. Furthermore, it does not appear that the funds rate needs to rise all that far during this economic cycle. These longer-term issues are likely to be discussed at length at Jackson Hole, shedding some light on the Fed’s latest thinking. It is likely that the resulting analysis will suggest that U.S. rates may not diverge much further from those of the Eurozone and Japan, as there will also likely be strong resistance to pushing non-U.S. yields to more negative levels, even if further easing steps are taken overseas. This reduction in potential rate divergence indicates that the U.S. dollar may adjust to this new reality by reversing some of its large gains of the past two years, and weaken by, say 5%. A bigger move of up to 10% is possible over time, if the outlook for global growth and inflation also brightens. In this case, higher beta currencies of emerging markets and commodity bloc countries would likely outperform the majors.

As we approach Jackson Hole next week, the US dollar appears poised for a further setback induced by a realization that U.S. rates, whether the Fed hikes again in 2016 or not, are no longer expected to diverge significantly further from those of major peers.

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