Strategic Currency Briefing

Outlook:

We get durables today, one of the few data points that has some real juice, although the stock market probably overrides today, Economists expect good numbers for the second month in a row, maybe not a dollar-booster but not a negative, either. We also get the crude oil inventory report, expected to be another build by 1.4 million barrels. Oil traders are befuddled by US production holding on despite price drops, what Iran means, and whether demand really is weak or the price is down because of oversupply. One thing not being given enough attention is that low energy prices, at least relatively low, are a Good Thing in their own right. Low prices put more cash in household budgets to spend on other things or to save, and may encourage new enterprises (or at least not discourage them).

New York Fed Pres Dudley will talk about the regional economy this morning, but of course reporters will drop that topic in favor of questions about whether the hike is coming in September (or at all this year). The last time we had a Fed speak, it was Atlanta Fed Lockhart, who said earlier this week that a rate hike is still in the cards this year. Since earlier he was pushing for Sept, this was an effort to be soothing that didn’t entirely work. Dudley is far more tactful and we would bet a dollar he gives absolutely nothing away.

If you like economic history, you need a subscription to the Wall Street Journal. It has been pulling out all the stops to generate buzz about the Sept FOMC. One historical nugget was already on our mind—the inadequate and bumbling Fed response to the Asian crisis in 1997. The Fed raised rates in March 1997 (by 25 bp to 5.50%), and kept it there until September 1998, after the Asia crisis had spread to Russia. Then the Fed started cutting rates and cut three times (to 4.75%). By May 2000, the Fed was raising rates again.

The WSJ writes “… the Asian financial crisis was more than a year old and it had morphed into a global crisis when the Fed responded by cutting rates in 1998. You can’t dismiss the possibility that the Fed might end up deciding to ease policy in this episode. China is too big and the world economy has proved too unstable and unpredictable to be sure it won’t happen. But it isn’t likely to happen any time soon.
The Fed is a very inertial institution and it is oriented toward raising rates, not easing.”

Separately, the WSJ reports “Fed funds futures contracts for October, November and December 2016 are priced for an average benchmark fed funds rate of 0.74% at the end of next year. For the fourth quarter of 2017 they are priced for an average benchmark rate of 1.29%. These rates have come down substantially since Fed officials last made public rate projections in June. Even then the Fed was above the market. Now it is substantially above the market.

“The median forecast among Fed officials for the fourth quarter of 2016 had the fed funds rate at 1.625%, nearly a percentage point above current market expectations. The median forecast for the fourth quarter of 2017 is 2.875%, more than a percentage point above current market expectations. Even the most dovish Fed official, with a fed funds rate projection of 2% in the fourth quarter of 2017, is well above futures market pricing of 1.29% for that period. (The Fed doesn’t identify which individuals make which forecasts in its ‘dot plot.’).”

To be fair, the market prices in things that Fed officials care less about, including the possibility of deflation/recession, which the Fed rates at low probability. “Still, Fed forecasts for the path of rates over the next three years look increasingly untenable in an era of persistently low growth and inflation. Other market indicators tell the same story. A two-year Treasury note maturing in August 2017 yields just 0.568%. That is inconsistent with rates of 2.875% in two years. Eurodollar futures contracts, which measure expected 3-month interbank borrowing rates in the future, are priced for a 1.69% interest rate at the end of 2017, also well below the Fed’s projections.”

In yet a third article, the WSJ tries to sell a new newspapers by asserting the Kansas City Fed shindig at Jackson Hole starting Friday will be forced to confront the current China and EM-driven crisis. Important analysts like former Fed Vice-Chairman Blinder are saying “Prior to these market events in the last few days, I thought that this was about as close to a 50/50 call as you can get. If the markets are in anything close to the sort of tizzy they have been in the last few days, then the Fed will not throw a match into the fire” when it meets September 16-17.

Well, maybe. But the speeches have already been written for Jackson Hole. Neither Yellen nor Draghi are attending. Actually, China is not attending, either. We expect to get some useful things out of Fischer’s speech on US inflation, although maybe not if he opts for the Philips curve theory. This would be consistent with Fischer’s other speech in May on the global responsibility of the Fed in which he resurrects Mundell-Fleming, as we reported earlier this week.

If we take Fischer at his word in that speech, the US disavows responsibility for the emerging markets having borrowed too much in US dollars. “Total corporate bonds outstanding in emerging markets have almost doubled since 2008 to $6.8 trillion, according to Institute of International Finance estimates. The share of this debt issued in U.S. dollars rose from less than 15% in 2008 to more than 40% in the first five months of 2015. Those debts become harder to pay off as the dollar appreciates. It is up more than 7% against a broad basket of other currencies so far this year.”

We may also want to downplay the China effect. In a NYT op-ed titled “False Alarm on a Crisis in China,” a Peterson Institute fellow and China expert named officer Lardy asserts that the correction in the Shanghai is perfectly appropriate in the grand scheme of things. “While not as overpriced, American equities before last week had experienced a six-year bull market without a correction. The catalyst for this month’s correction was the view that China’s growth was weaker than advertised and likely to soften further and that the currency depreciation that began earlier this month was China’s last gasp at propping up economic growth. The perception that China’s growth was slowing drove commodity prices to new lows, further weakening emerging markets such as Brazil and Chile that are big commodity exporters, and eventually driving down American equities sharply. But if China hadn’t been the catalyst for the correction in American markets, it most likely would have been something else.

“Despite what many think, not all debt is the same, nor are all equity market slides. There have been many more corrections in both the United States and China than there have been financial crises. Allowing those corrections to take place is part of letting markets determine outcomes, which is a good thing.
“And that is what the government of China is now doing, both with respect to the exchange rate and belatedly in more recent days, to a surprising extent, with the equity markets. There remain concerns over Chinese real estate and state-owned enterprises. But recent events should be seen as part of the conscious liberalization and rebalancing of the Chinese economy. Even if that means a sell-off in stocks, it is not a sell-off in the fundamentals of the Chinese economy. In fact, this may strengthen those fundamentals by going further down the path to reform.” Golly, common sense from an ivory tower egghead.

But another brainy guy, David Stockman, continues to harp on structural problems in China. The WSJ reports he is worried that “in the late 1990s, China had the capacity to manufacture 100 million tons of steel. That figure today is 1.1 billion tons — almost twice the amount of annual demand for steel in China. The China steelmaking boom also sent the price for iron ore up to nearly $200 a ton in 2011, from around $30 in 2008. Like all commodity prices, it has fallen sharply, to just under $100, a correction that creates problems for big iron ore-producing countries like Australia, which made huge investments to keep supplying these raw materials to China. ‘Iron ore is the canary in the steel shaft if you will,’ Mr. Stockman said. ‘It is a real measure of the violence of global deflation that is currently underway.”

Maybe China really is on the brink of disaster…. But we shouldn’t take the gyrations of the stock market—with a 7% participation rate—to define it.

Finally, what’s the latest about September? Market News reports that one camp sees Sept as entirely off the table, with the China effect acting just like the Taper Tantrum that forced a delay two years ago.
Both the other camp, including ScotiaBank, say Sept is still on the table. "It would not be healthy to price out a hike completely, only to have to price it in again at a later date." Citibank analysts have been loudly agreeing all week. RBC agrees, if the stock market cooperates, and JP Morgan economist Feroli said "Odds of a September liftoff have dipped below 50%, perhaps to around 35-40%. Even so, we still think the odds of liftoff are greater for September than for any other single meeting." The favorable economic outlook "may get swamped by renewed concerns about the global outlook,' Feroli said, but if the Fed defers on September, odds are quite high that first hike will happen this year -- do not rule out October.

Good grief. Important names still favor September. Who would have thought it? We think it’s a remote possibility because the current Fed is cowardly, but start getting ready to be surprised. Maybe the dollar is not toast, after all.