Via Scotiabank's Guy Haselmann,
Rapidly Standing Still
While global central bank quasi-coordination ended in 2014, it completely diverged in 2015. This is highly troubling and dissimilar to other historical comparisons. The reason is because when both nominal and real interest rates are already zero and/or negative, cutting interest rates further is an action taken to directly weaken the currency. Making real rates more negative will simply not lead to more borrowing for capital spending. Therefore, the BoJ’s easing last week sounded an alarm that a currency war has basically begun.
By cutting rates, the BoJ has made the Fed’s job more difficult. A continuation of diverging policies would ultimately place too much upward pressure on the US dollar. One reason the dollar materially slipped today is due to this realization and the market reacting to further price out Fed hikes.
Because a currency represents a relative relationship, Fed hikes could have helped pull other central banks away from the dangers and consequences of negative rates, while still helping their hidden desire for a weakened currency. Opposing central bank policy actions would cause too powerful of an impact on exchange rates. Unfortunately, it appears the path into negative territory is winning the directional battle. A classic prisoner’s dilemma has arisen for the Fed.
The pressure for China to devalue its currency is now stronger as well. This is not only true because Japan is a key trading partner, but because China recently shifted its policy from a USD fixed exchange rate to a trade-weighted basket that includes the yen. (Similarly, further cuts in Europe are intended to weaken the Euro.)
A strong dollar has always posed one of the biggest risks to the derailment of the Fed’s hiking cycle. A rising dollar causes real exports to decline, because the relative price of US goods in foreign markets is higher. Concurrently, foreign goods are cheaper to US consumers, so real imports rise in the US. US slack increases as domestic production declines, resulting in lower GDP and lower prices. In other words, global output becomes redistributed away from the US.
Currency wars are a zero sum game. However, they can be a negative sum game if they lead to protectionism or other anti-globalization retaliatory measures. Currencies are targeted when there is a deficiency of good or effective policy options. Unfortunately, Japan, China, and Europe cannot all become more competitive against each other at the same time, and attempts to do so destabilize markets and propagate imbalances.
Stanley Fischer is one of the most experienced and wily central bankers in the world. His shrewd insights are influential. Many on the FOMC (and elsewhere) look to him as a ballast and beacon for navigating highly turbulent financial markets and economic waters. His calm and unflappable demeanor shrouds a deep understanding of economic and financial market issues, and the first and second-order effects of monetary policy.
It is interesting and no coincidence that several of his recent speeches have addressed exchange rates and risks to financial stability (see here and here). In an interview with Tom Keene on Monday, he commented at length on the question of currency wars. Fischer said to Keene, “The agreement is that the international body of policy makers frowns upon measures undertaken solely to weaken a currency….if you are trying to change the exchange rate purely to get an advantage against other countries, that’s not ok”. Fischer sounded as if he was warning other central banks.
My colleague Dov Zigler wrote an excellent note on this interview:
Fischer is downgrading his inflation outlook due to the strengthening of the USD. He says: “Further declines in oil prices and increases in the foreign exchange value of the dollar suggested that inflation would likely remain low for somewhat longer than had been previously expected.” This could mean that FOMC members, including Fischer, will also reduce the part of their forecasts tied to the inflation outlook — namely, forecasts for the appropriate path of monetary policy. Much will thus depend on what happens to the USD over the weeks between now and the March FOMC meeting. We wrote about this in Daily Points this morning. It is a material risk.
Fischer commented at length on the question of ‘currency wars’ — and implied that the FOMC has very little patience for central banks engaging in them. At the conclusion of the Q&A, Fischer was asked by the moderator about ‘currency wars’. What Fischer said bears quotation at length because it speaks to a potential impact on Fed policy from international monetary policy actions. Fischer said: ‘There’s an agreement among countries. It is an inevitable result of an easy policy that your currency weakens. There is an agreement among international policy makers. The agreement is that the international body of policy makers frowns upon measures undertaken solely to weaken a currency. If the conclusion is that you are involved in an effort to strengthen your economy [via monetary easing]… that’s ok. If you are trying to change the exchange rate purely to get an advantage against other countries, that’s not ok.” The question is thus whether or not the FOMC thinks that recent actions by major central banks, which have had the effect of weakening currency crosses against the USD, were undertaken with bona fide economic logic other than currency depreciation in mind. The tone of the Fed Vice Chair’s comments implied that he might have his doubts.
The Fed is not worried about the unemployment rate falling ‘too much’ and will not necessarily conduct monetary policy in order to cool off the labor market at least in the near term. To that effect, Fischer asks: “Should we be concerned about the possibility of the unemployment rate falling somewhat below its longer-run normal level, as the most recent FOMC projections suggest? In my view, a modest overshoot of this sort would be appropriate.” Don’t expect the FOMC to hike aggressively just because the labor market is improving incrementally.
The Fed isn’t making any final judgements about whether or not the recent market volatility should cause it to alter its policy normalization plans — but it could alter its plans if the volatility gets too extreme. Writing about the volatility in asset markets triggered by a mix of falling oil prices and uncertainty about China, Fischer says: “If these developments lead to a persistent tightening of financial conditions, they could signal a slowing in the global economy that could affect growth and inflation in the United States. But we have seen similar periods of volatility in recent years that have left little permanent imprint on the economy. As the FOMC said in its statement last week, we are closely monitoring global economic and financial developments…” Fischer sounds taciturn here, and to his credit, both has perspective amidst a volatile market and remains flexible and open minded with respect to how the Fed should respond to it.
Fischer wants to maintain a large Fed balance sheet for ‘a time’. It should be clear from other recent Fed comments that the FOMC intends to maintain a large balance sheet. Fischer however added a wrinkle today.
Risks to financial stability, which are intertwined with the level of the USD, likely played a role in the Fed’s decision to hike rates in December. Political aspects, which some FOMC members are only willing to admit in closed door meetings, also played a part. Congress generally views interest on excess reserves as an unpalatable ‘giveaway of taxpayer money to banks’. Ironically, a 0% rate is also criticized.
The Fed has a tricky balance of trying to find (and not veer too far from) the ‘neutral rate’, while simultaneously managing an enormous balance sheet and restraining as much political opposition as possible. In this regard, putting some distance between 0% and the Fed Funds rate therefore has its benefits, as both negative rates or a QE4 program (should it be necessary) would be highly problematic from a political point of view. Although the argument might sound stupid, by lifting rates, the Fed has the ability to move back down to 0% before resorting to these other ‘contemptuous’ actions. The FOMC is certainly in a quagmire.
As I have been writing for over a year now, “all roads lead to Treasuries”. I have outlined the many reasons on numerous occasions. I still expect long-dated Treasuries to be one of the best trades of the year. I expect them to move to new all-time low yields in 2016 (i.e., 10’s and 30’s below 1.39% and 2.23% respectively).
“They disguise it. Hypnotize it. Television made you buy it.” – System Of A Down
via Zero Hedge http://ift.tt/1KY9npg Tyler Durden