Dollar Drivers

The events of the past week will continue to reverberate in the capital markets in the week ahead. The key development was the market’s ultra-dovish read of the Federal Reserve. Although the dollar recouped the lion’s share of the knee-jerk losses, the debt markets have not returned to status quo ante.

Many, if not most market participants fail to appreciate our heuristic insight into the Federal Reserve:  Policy emanates from the leadership of the Federal Reserve: Yellen, Fischer, and Dudley. We argue that the key organ of the leadership is the FOMC statement. Other communication tools including the dot-plots and the FOMC minutes have a higher ratio of noise to signal. 

The FOMC statement dropped the word patience, completing the transition from a date-approach to forward guidance to a data-driven approach. Fearing that the markets would conclude that a hike was imminent, the statement offset the seemingly hawkish development with an acknowledgement that the economic growth had moderated, and exports had slowed. Other than that the FOMC statement was little changed from January.

Participants emphasized the dot-plots and in particular, the dramatic reduction in the anticipated path of the Fed funds target. We want to emphasize three points here. First, our understanding is that many Fed officials see the dot-plots as a largely failed experiment and would like to jettison it. However, this is easier said than done. Yellen herself has played down their importance.

Second, the past dot-plots exposed a large gap between it and market expectations reflected in OIS, Fed funds futures, and Eurodollar futures. It remained an open question how that gap was going to close. The evolution of the dot-plots, last week showed Fed officials adjusted their views dramatically and brought them more in line with the market expectations. The previous configuration of dot plots did not persuade the market of a hawkish tilt. We suspect that markets exaggerated the dovish signal in the dot plots.

Third, Yellen reiterated that the dot-plots are a function of individual forecasts. Of the skills necessary to become a regional Fed president, a robust ability to forecast the economy is not particularly salient. In December, there was a couple of regional Fed presidents that anticipated (i.e. wanted) the Fed to hike rates in March-April.

What has been lost on many observers is the change in personnel.  Plosser, the outspoken hawk who led the Philadelphia Fed retired on March 1.  His successor, Harker,  a director of the Philadelphia Fed for the past three years, will assume the post as of July 1.  He is perceived to be somewhat less hawkish and more in line with the Fed's leadership.  At the March FOMC meeting (and at the June meeting as well) First Vice President Prichard will temporarily take on the duties.

Dallas Fed Preisdent Fisher, another outspoken hawk, stepped down after last week's FOMC meeting. His successor has not been named.   The First Vice President of the Dallas Fed Holocomb will serve in the interim until a successor is named.   Previously Plosser and Fisher had advocated a hike in March/April. This is obviously not going to happen, and the forecasts had to be adjusted accordingly.

The fact that Q1 growth is tracking much lower than officials expected requires an adjustment to the forecasts for the entire year.   This was the case last year as well after it become clear that the economy contracted in Q1.  Yellen went to pains to stress that even with the downgrade of the Fed’s growth forecasts, it continues to expect growth to be above trend.

There is also much confusion about the Fed’s view of the dollar. Contrary to what some had expected, there was no mention of the dollar in the FOMC statement itself. Most of Yellen’s remark about the dollar during the press conference were not instigated by the Chair, but by inquiring reporters, many of whom later wrote stories about the increased importance of the dollar in setting Fed policy.  

Yellen accepted that the rise in the dollar was one of the factors that were slowing exports. Reporters did not press further: If the dollar was one of the factors, what were the others? If they had, we suspect Yellen would have explained that the IMF and World Bank had cut their forecasts for world growth. We think that the data bears out our contention that the best thing for US exports is stronger world growth.

Yellen also noted that the strength of the dollar was dampening inflation through import prices. Many participants completely ignored the rest of her comments about this, and in particular that this was a transitory development. Few reports covering the Fed thought it worth mentioning that Yellen acknowledged that the dollar’s appreciation was partly a reflection of the strength of the US economy.

We suggest that Yellen’s testimony before Congress in late February sheds light on Fed’s thinking. She indicated that the dampening impact of the rise of the dollar is broadly offset by the fall in oil prices. The claim that Yellen has waded into the so-called currencies wars is far from the mark. Indeed, we expect that the dollar will be stronger not weaker when the Fed raises interest rates. Vice Chairman Fischer’s speech to the Economics Club in New York on March 23 should be closely monitored. He is the first of the Fed’s leadership to speak since the FOMC meeting.

The US economy contracted in Q1 14, and yet the Fed continued to taper. It stayed on course. Similarly, Q1 15 grow is set to be disappointingly weak. Part of this is weather-related. Part of this is a function of the labor dispute in the West Coast ports. US consumption surged in Q4 (more than 4% annualized rate) and appeared to be pulling back in Q1.

We anticipate better economic data will be forthcoming in the months ahead. Next week’s economic data may be constructive (a tick up in CPI, an upward revision in Q4 GDP), but pales in comparison to the employment data in early April. In this context, we find Yellen’s comment, which was obscured by the doves' cry, that rates are likely to rise before earnings growth accelerate is particularly significant.

The modest uptick in euro area activity and in lending conditions we identified prior to the launch of the ECB’s sovereign bond buying program remains intact. The flash PMI and money supply reports will likely confirm this. The composite is expected to edge up from February 53.3 reading. Eurozone data has consistently surprised the market here in Q1, and we expect market expectations are being adjusted. Growth here in Q1 is likely 1.5%-1.75% at an annualized rate.

Financial conditions are also improving. Money supply growth is accelerating. Last February it was rising an at anemic 1.3% year-over-year pace. When reported on 26 March, the pace likely have accelerated to 4.3% from 4.1% in January (best in six years). Moreover, and with implications for the Targeted Long-Term Repo Operation (TLTRO), private sector lending is improving. After contracting for 2 ½ years, lending posted positive readings in December and January, and likely extend this for the third month.

Core banks appeared to participate more in the first two opportunities to tap the TLTRO facility last September (82.6 bln euros) and December (130 bln euros). However, banks in the periphery seemed to be more active participants in last week’s operation. Italian banks were thought to have taken down nearly a third of the 97.8 bln euros borrowed under the TLTRO offering. The overall take down was a the high end of expectations.

There are two elections in the eurozone this weekend that may not have much immediate market impact, but will feed investors' anxiety about the political outlook.   Spain's Andalusia holds a regional election.  It is a strong hold for the Socialist Workers Party (PSOE) but Podemos can deny it an outright majority.  France holds the first round of local elections and a strong showing by the National Front is expected.  It has a candidate running in nearly every constituency, more than the main two parties (UMP and Socialists).   The results will be known before the markets open on Monday.

The UK reports February inflation and retail sales. The year-over-year CPI is expected to fall closer to zero. The low CPI reading will follow the disappointing average earnings data and will reinforce the dovish tone of BOE Governor Carney and BOE Economist Haldine. The implied yield of the June 2016 short-sterling futures contract has fallen by more than 30 bp in the past two weeks to 90 bp as the pendulum of investor expectations pushes out a UK rate hike further. A constructive retail sales report (consensus forecast 0.4% after -0.3% in January) is unlikely to reverse this recent development.

There is a full slate of economic reports from Japan. These include the preliminary March PMI, February unemployment, CPI and retail sales. On balance, the weak economic recovery that began in Q4 14 is carrying over into the start of this year. Of note, several of the large auto companies are raising base wages and this will likely underpin overall household spending going forward. Retail sales are also expected to have recovered from the 1.9% decline in January (consensus forecast is for a 0.9% increase in February.

However, despite the aggressive easing of Japanese monetary policy, price pressures have not been rekindled. The core rate, which excludes fresh food, is expected to ease to 2.1% from 2.2%. When last April’s sales tax is excluded, as the BOJ does for its target, consumer prices are essentially flat on a year-over-year basis. BOJ Kuroda recently warned the market that CPI may be around zero for the next few months. He seems in no immediate hurry to expand the BOJ’s asset purchase.