Don't Discount the Dollar

The US dollar has fallen about 2.25% against the euro and the yen over the past week, its poorest weekly performance in a couple of months. Every one has their own pet theory to explain the move, but the risk is that the move has been exaggerated and that a more stable dollar tone will emerge in the coming days.

Many explanations of the dollar’s slide focus on the larger than expected US current account deficit and the less than expected foreign demand for US securities, as picked up in the Treasury’s monthly portfolio flow report (TIC), within the context of indications from a couple Middle East countries that they are considering reducing the dollar component of their reserves. Others suggested that the criticism over the apparently ever growing US current account deficit by a few G7 officials raises the possibility of a mini-Plaza-like agreement to force a dollar-adjustment.

This is largely noise. Of course it is true that the US has a large external deficit. That is hardly news. Neither the size nor the direction of the US trade deficit or current account deficit provides a useful or meaningful indicator of the direction of the US dollar.

Foreign purchase of US bonds and stocks did not cover the US trade deficit for the second consecutive month, but this is a poor metric. The TIC data is not comprehensive of all capital flows. For example, it does not include direct investment, which is the other main component of the basic balance approach. It also does not include much of the hot money or speculative capital flows.

The traditional argument is that hot money is less stable than the long-term portfolio and direct investment. While intuitively this might maker sense, there is less to it than meets the eye. For example, one of the main reasons for the disappointment with the TIC data was the Treasury sales from the Caribbean, the bulk, even if not the entirety, of which is thought to be hedge funds, i.e., speculators. On the other hand, when an affiliate of a US company retains their foreign earnings locally that is considered as new direct investment, but it is often more liquid than is usually recognized by conventional wisdom.

There were some confusing reports that Syria and Dubai may consider diversifying their reserves away from US dollars. Their reserves are minor and such moves are inconsequential. The argument some observers make that private Middle East flows may also move away from US Treasuries is pure conjecture and lacking any evidence. In fact, the latest TIC data showed OPEC countries continued to buy US assets in January. A recent paper by the Bank for International Settlements found that interest rate differentials had a strong role in explaining how OPEC recycled its petrodollars. Moreover, even if one were to subscribe to some kind of domino theory, surely no one really thinks that Saudi Arabia or Japan or China are going to follow Dubai or Syria’s reserve management decisions.

Some observers also confuse reserve management decisions as an expression of a country’s view of the United States. This simply misunderstands the reserve management decisions. Canada’s decision several years ago to diversify its reserves is a compelling example of this point. The US absorbs something on the magnitude of 90% of Canada’s exports and the bilateral trade is the largest in the world and the 49th parallel remains a largely porous boarder. Yet Canada has only about 54% of its reserves in dollars, well below the 70% of industrialized countries’ reserves that are in US dollar denominated assets. Canada has 42% of its reserves in Europe and 3% in yen. This says little about the role of the US dollar in Canada. Try offering a Canadian taxi driver euros or yen for your fare, if you doubt this assessment.

Rather the most compelling explanation for the dollar’s hit is a sharp, and likely exaggerated, shift in US interest rate expectations. The direction of the swing in the pendulum of market sentiment is not unexpected. As recently as Monday March 13, the market was leaning toward the possibility that the Fed would not pause and instead hike at each of the next three FOMC meetings: March 28, May 10 and June 29. This seemed exaggerated to us last week. (See previous post  “The Dollar and Emerging Markets”).

However, what is surprising is the violence of the swing in sentiment and the magnitude. In fact we suspect the swing in sentiment has gone too far. The Fed funds futures strip now indicates that the market is no longer convinced that the Fed funds target will even reach 5% now. The market is exaggerating the impact of the recent data and comments.

To be clear, the market remains certain that the Federal Reserve will hike the Fed funds target to 4.75% on March 28, so the real impact of the February data released this week and the comments by Fed officials is on what the Fed may or may not do in May and June. Whatever variables the Fed looks at to set monetary policy, surely Feb’s economic data will not be salient to the decision in May or June.

The case for Fed tightening is not and has not been based on current inflation, but on the risks to inflation. Those risks are substantial. Essentially the argument is that the macro-economic readings are too robust to allow the Fed declare victory in their normalization of monetary policy.

There are several areas that pose risks to price stability. Individually, one might try to explain some mitigating factor, but taken together they paint a compelling picture. Consider:

• Despite the noise and statistical quirks, the economy is growing well above trend here in Q1 (the consensus is for something just shy of 5%) and trend growth for the next several quarters.

• The tightness of the labor market is evident by sub-5% unemployment rate, with 200k jobs being created on average in recent months and hourly earnings rising at their fastest pace in years.
• Capacity utilization, which is one aspect of the Fed’s euphemistic reference to resource utilization rates, is at its highest level in several years and is approaching the past cyclical high.

• Productivity growth continues to trend lower and this reduces if not removes one of the offsets to price pressures.

• Despite the Fed raising the price of money, it continues to allow the quantity of money to grow robustly. In fact, some of the broad measures of money supply are growing faster now than six months ago.

• Real interest rates remain low. If one subtracts headline CPI (3.7% year-over-year in Feb) from nominal note or bond yields, the real rate is less than 100 bp. Even if one wants to use core CPI, the real rate is still close to 50 bp below the long-term average.

Lastly, the market is likely misconstruing comments from Fed officials to justify what they want to do. For example, when a Fed official says that price pressures may moderate, it is not independent of the Fed’s action. Nor is the recognition of the Fed’s historic tendency to raise rates too much the same thing as saying that it is a risk at the present. One can still accept that a neutral Fed funds level is desired, but simply suggest that neutrality is a range (3.5%-5.5% a la Yellen) and simply that these risks require the upper end of neutrality.

What all this means is that the dollar’s slide in recent days has likely been exaggerated and look for the greenback to find better footing next week as cooler heads prevail. Although there might be an attempt at the start of next week to extend the euro’s gains, resistance is likely to be encountered in the $1.2220-40 area, there is likely to be a retracement of this week’s gains. Look for a test on the $1.2070-$1.2100 area. A break of this area could see another cent decline.

The dollar dropped against the yen to test the early March low near JPY115.45. Ahead of the Japanese fiscal year end at the end of this month, yen is likely to remain well support on the crosses, which may limit the greenback’s ability to recover against the yen in the days ahead.