Fed inching towards ownership of the USD as an economic factor

Outlook:

We noted in a book in 1999 (CNBC 24/7—Trading Around the Clock, Around the World) that it had gone out of fashion to compare stocks and bonds in yield terms. As US interest rates fell over the past few years, dividend yield returned to the fore as an important variable, but there was still a distinct shortage of analysis making the direct comparison.

Now the FT embraces this old-fashioned concept with open arms, writing that “The yield on German 10-year Bunds is just 0.09 per cent, off 1 basis point on the day, while 30-year German paper is offering only 0.47 per cent. The FTSE Eurofirst 300 has a trailing dividend yield of 3.2 per cent, according to Bloomberg data.

“A similar rationale is contributing to a strong bull run in Japanese shares. The 10-year government bond yield is 0.31 per cent as the Bank of Japan snaps up domestic sovereign debt as part of its massive quantitative easing strategy, which is designed to banish deflation. The Nikkei 225, which sports a trail-ing dividend yield of 1.3 per cent,” closed over the 15-year high today.

The FT doesn’t mention it, but in China, the interest rate on savings deposits is kept artificially low to fund the banks on favorable terms. If China wants to deflate the equity bubble, all it has to do it let rates float to a better level. As we know, Chinese are terrific savers.

Bottom line—talk of bubbles in many places is probably justified. Pretty soon we will start hearing about P/E’s at silly highs. But unless and until interest rates are normalized, the equity markets have a giant unfair advantage--and this is true just about everywhere, not just the US and China. It’s interesting that the two biggest global economies are both suffering under the weight of artificial interest rate levels. What happened to “let the market decide”?

As for normalization in the US, the WSJ chief Fed-watcher Hilsenrath writes today that “The strong U.S. dollar and an unsteady global economy are emerging as primary concerns for Federal Reserve offi-cials…” The headline reads “Fed’s Rate Decisions Hang on Dollar, Growth Concerns.” Hilsenrath is annoying and not always right, but he does have inside informants and is presumably a top destination for deliberate leaks.

He says “As they discuss the outlook beyond midyear, officials are increasingly weighing how much the strong dollar might have hurt the prospects of achieving their economic forecast of annual growth of around 2.5%, gradual increases in inflation and continued declines in unemployment.”

The strong dollar is cutting import prices and thus inflation in general. Boston Fed Pres Rosengren men-tioned the dollar only on Monday, saying the dollar and divergent global growth paths are an important set of factors in the Fed’s outlook. NY Fed chief Dudley said much the same thing: “While I am rela-tively optimistic about the growth outlook for 2015, I also must acknowledge that there are some signifi-cant downside risks,” he said. “In particular, the roughly 15% appreciation of the exchange value of the dollar since mid-2014 is making U.S. exports more expensive and imports more competitive.”

The WSJ goes on, “New York Fed economists estimate the dollar’s appreciation could reduce the growth rate of U.S. economic output by about 0.6 percentage point this year. The Fed’s increasingly open discussion of the dollar outlook is unusual. The central bank tends to minimize its comments on the currency to leave discussions of foreign-exchange policy to the U.S. Treasury. In this case, Fed officials are trying to stay focused on the exchange rate’s effects on the economic outlook. Yet it becomes impos-sible to disentangle that from the Fed’s own interest-rate policies, which in turn influence the dollar.” The WSJ links the cut in growth forecasts by big-house economists (from 3% to 2.7%) directly to the dollar, at least in part. And oh, yes, the drop in energy costs. “As growth expectations diminish, so are market expectations for a Fed move. The central bank has held its benchmark short-term interest rate near zero since late 2008. Since March, investors in futures contracts linked to the rate have signaled they see diminishing odds of a rate increase even by September.”

The Fed has a “communication problem” that “is rippling through currency markets rather than bond markets, but the net effect is a similar drag on the economy. The Goldman Sachs Financial Conditions Index—which tracks the broad effects of interest rates, stocks, currency and other factors on the availa-bility of money—reached a level of financial restraint in mid-March that it hadn’t reached since the ta-per tantrum of 2013.” The Fed worries about saying too much or too little and causing instability instead of tamping it down.

We say the Fed is missing the obvious. This happens sometimes to people who are too smart for their own good. The Fed can stand up on its hind legs and name a price range it prefers to see the dollar in order to get the growth and inflation that are the true targets. Central banks always get in trouble when they do that—think of the backlash against Japan—and it would violate the G7 agreement that nobody will try to influence exchange rates—but never mind. The US is exceptional is more than one way, and making up the rules it chooses to follow is one of them. Australia and Canada have done it. The Europe-ans do it periodically—remember Trichet naming the euro peak as “brutal”—twice. It could be subtle or it could be brash, but it looks like the Fed is inching toward ownership of the dollar as an economic fac-tor.

We haven’t heard a peep out of Treas Sec Lew that the Fed is stepping on his toes. We have resisted this view for a long time but now we get it—the Fed is poaching on the Treasury’s land. It doesn’t have “authority,” so to speak, but it does have logic and history on its side. Even the President mentioned the dollar in speaking of the new Asian trade deal he is seeking, saying the trade partners know we are watching their currencies like a hawk. This is a policy shift. Technically, jaw-boning the currency should work only when the threat of intervention is real, but in practice, the Fed has tremen-dous power to move markets with just a word or two.

As for the immediate future, it’s only a matter of time before the dollar recovers and the euro resumes its downmove toward parity and worse. But we admit it could be a long time and the goal is to avoid going broke before “trend continuation” resumes.