Dudley upset the apple cart yesterday. He went from being a liquidity-worrier that made him somewhat dovish to being a full-bore normalization promoter. If you were ignoring the Fed speeches this week, and there are plenty, you got a comeuppance (we did).
Dudley came right out and said the bond market has it wrong by failing to price in a pretty good econo-my and central bank resolve. In a parallel to Greenspan's "conundrum" back in the 1990's, Dudley ar-gued that yield-seeking international capital flows are driving yields, not failing economic momentum. This is two birds, one stone. Markets should have confidence in the Fed—the June hike was warranted and the next one will be, too. Falling yields were signaling a lack of confidence in the Fed's projections and the Fed's assumptions about wages and inflation inevitably ensuing from full employment. But the Fed sees no reason for expectations to point downward. Meanwhile, the economy is stable and growing. The Fed needs to hike to avoid any last-minute rush if and when inflation does appear. In other words, the dip in inflation is transitory.
Everyone appreciates that the Fed can't talk about energy prices directly. For one thing, energy prices are excluded from the core PCE inflation data that the Fed uses. For another, oil and food prices are ex-cluded because there is nothing the Fed can do about them, unlike things like mortgage rates. But realis-tically, energy prices pervade the entire global economy and affect all kinds of seemingly unrelated pric-es, including those core items that we do want to count. It's not hard to draw a line of cause-and-effect from energy prices to housing data, for example, or imports (lower global shipping costs). Would Ama-zon Prime have succeeded so mightily in an era of rising transportation costs? Macy's should blame frackers for its lower customer traffic.
The decline in energy prices and the outlook that the US can fill all the new world demand this year without a price hike is a stunning change. We are no longer the victim of the OPEC cartel. We may be ruining the environment, but that's the price of escape from bondage, aka reliance on imported oil. This is a Very Big Deal. The US has been seeking energy independence since the first oil embargo in 1973. The quest was badly managed, interfered with by the oil industry, rejected by Detroit, and generally in-fested with obstacles left and right.
In the end, it was technology that saved the day, not government regulation. Jimmy Carter told us all to turn down the thermostat and wear a sweater (he never spent a winter in New England). Clinton-Gore and Obama subsidized solar and wind. (Bush Two had worked in the oil industry in Texas and kept his hands off the industry.) Trump backing out of the Paris climate accord only disclosed that the public is deeply committed to reducing reliance on oil.
It's not clear we all get the point. Boom-bust cycles in oil prices may be, finally, over. We can still have volatility but the price range may be constrained to (say) $35 to $65. At $35, shale will struggle. The break-even seems to be about $40-45. But at $65, it comes roaring back.
How much weight the Fed puts on this development is not something the Fed is telling us. But it's a logical deduction. To the degree energy prices were the ultimate driver of inflation in recent decades, that era is over. The new era will have inherently lower inflation and thus inherently lower base interest rates.
If so, that may imply that the interest rate differentials that move the FX market will become ever-smaller. In the old days we though the US had to offer a premium of 2.5-3.5% over others to offset the twin deficits, Now that premium has shrunk.
Besides, the very concept of normalization is a favorable one. It means the crisis is really, truly, finally over. Rinehart and Rogoff told us to expect 8-10 years, and they were right. Meanwhile, Japan is going into its third decade of deflation. The eurozone may be emerging from the crisis, but the real Bund yield is still negative.
As for the UK, nobody knows. Chancellor Hammond said that protecting the financial services industry is the first priority in Brexit. You have to wonder how the voters feel about that. BoE Gov Carney said now is not the time to raise rates because of high uncertainty, despite the three dissents. Britain needs to expect weaker income growth until the trade deal is hammered out—some 500 days from now. Oh, yes, and businesses should be preparing contingency plans for the transition, as though they hadn't already thought of that. We are a devoted Anglophile but this is a mistaken appreciation of the situation on a stunning scale.
The BoE feels it cannot normalize while Brexit is making conditions anything but normal and uncer-tainty about everything is so high. At a guess, inability of businesses and government to make reasona-ble plans will destroy public confidence. It's not clear this is something the BoE can acknowledge until consumer spending goes to zero. George Soros said, according to Bloomberg, "We are fast ap-proaching the tipping point that characterizes all unsustainable economic developments. The fact is that Brexit is a lose-lose proposition, harmful both to Britain and the European Union. It cannot be undone, but people can change their minds. Apparently, this is happening."
The Brexit referendum was a year ago this coming Friday. The UK has made zero progress in prepar-ing for Brexit. None. Zilch, Nada. This cannot end well.
We see a sea-change in the world. Here's our list:
Oil prices will stop gyrating and will be confined in a range of $35-65 for several years. The infla-tion outlook is tame for the foreseeable future.
The US business cycle will become longer. We are already in the longest recovery on record. We have a new era in emerging markets: —China will continue to increase in size and importance once MSCI accepts its equities in the Emerging Markets index after the close today. —Argentina's 100-year bond got demand at more than triple the amount on offer.
The UK is going down the rabbit hole.
Are we entering an age of a stronger dollar? Forecasting a strong dollar almost always ends in tears. But golly, that's what it looks like. If your choice is a negative real return in JGB's/Bunds or 8% in Ar-gentina, it's no contest if you expect tame inflation. Even if you don't like the sovereign risk in Argen-tina (or Mexico), the negative return on JGBs or Bunds is fatal and you will seek some yield, any yield. Might as well be the US (or Australia...). Unless Trump starts a war, and even then, war is good for the US economy.
The old stand-by, "when in doubt, sell dollars," may be a bad strategy these days.
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