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FX: Why can the Fed never catch up and what turns the US dollar lower?

Quarterly Outlook
John Hardy

Head of FX Strategy

Summary:  At the Federal Open Market Committee (FOMC) meeting on 15 June, the Fed hiked rates by 75 basis points (bps) for the first time since 1994. It’s on the path to tightening policy at the most rapid pace since the Volcker Fed in the early 1980s, all while also shrinking its balance sheet, a factor that was not in play in that era. The US dollar has surged in correlation with the steady repricing of ever more Fed tightening. It will likely only find its peak and begin a notable retreat once either the economy lurches into a disinflationary demand-induced recession or the market realises that the Fed can never catch up with the curve, because if it did, it would threaten the stability of the US treasury market.


Peak USD only once the runaway inflation train has crashed? 

The nearly unprecedented pace of Fed tightening this year has seen the Fed hike rates 150 bps in the space of three meetings, and the market has priced another 200 bps of tightening for the 2022 calendar year. If tightening proceeds as expected, that will be a total of 350 bps in a brief space of a nine months. Consider that it took Yellen and Powell three years to hike 225 bps and Greenspan and Bernanke nearly two years to hike rates 425 bps—and that’s without the quantitative tightening (QT) of the post-global financial crisis (GFC) era. In short, the Fed has not moved at this pace since the early 1980s.  

And yet, the Fed still tries to push back against over-the-top tightening expectations even after its tardy start to the hiking cycle. At the FOMC meeting on 4 May, Fed Chair Jerome Powell specifically pushed back against the idea of hikes larger than 50 bps, only to hike by that much on 15 June, after what many believe to be the Fed guiding the market via a WSJ op-ed. Then, at the 15 June press conference, Powell tried to float the idea that the July hike might be 50 bps instead of 75. Clearly, the Fed retains the fervent hope that the current high inflation levels will still eventually prove transitory. This is in abundant evidence in the latest Fed staff economic projections as well, where the June FOMC meeting refresh still puts the 2024 expected personal consumption expenditures (PCE) core inflation at 2.3 percent. This is no change from March, although the Fed actually lowered the projected core inflation reading for 2023 and the headline inflation for 2024 by -0.1 percent. As we express in this outlook, the risk is that inflation is a runaway train and the Fed is still chasing from behind the curve, never able to catch up, as I argue below. 

One argument for how the US dollar might peak and begin its turn lower despite the Fed’s tightening regime is that many other central banks are set to eventually outpace the Fed in hiking rates, taking their real interest rates to levels higher than the Fed will achieve. This very development has been behind a few emerging market (EM) currencies like BRL and MXN already posting the kind of resilience one might never have thought possible in an environment of rapidly rising US yields and a stronger US dollar this year. But within a G10 FX context, outside of the important exception of USDJPY, most US dollar pairs haven’t shown much correlation with the developments in yield spreads driven at the front end of the curve by central bank policy expectations or at the longer end of the yield curve. Take a pair like AUDUSD, where the Reserve Bank of Australia (RBA) hiking expectations have now caught up and surpassed Fed expectations for the coming nine months, and where the 10-year Australian government bond yield (as of late June) traded 80+ bps higher than its US Treasury Note counterpart, compared with a range of 0 to 50 bps for the first few months of this year. This leads us to believe that the dominant strong US dollar driver in this cycle is the US dollar’s global reserve status and the simple directional fact of US inflationary pressure requiring the Fed to continue to tighten. This wears on sentiment and global financial conditions. If that is the case, then the USD will only begin turning once economic reality finally flounders, sufficiently reversing inflation via a demand-induced recession. Only then will the US dollar finally roll over after its remarkable ascent to its highest level in more than 20 years.  


Why the Fed can never catch up 

With the huge fiscal outlays to combat the pandemic in the US in 2020 and 2021—some $5 trillion in total—came strong new fears about the fiscal sustainability of the US government. Fast forward to 2022 and we discover that the booming asset markets in 2020 and especially 2021, as well as record boosts in personal income from the huge pandemic cash splash, brought enormous tax revenues, helping to ease these budget concerns, even if only temporarily. While things don’t look too alarming for this calendar year, the next few years will likely prove a different story. That’s because since the 1990s, tax revenues have become increasingly correlated with asset market returns—and these are looking a bit ugly for this year, to say the least. The brief 1990 recession and bear market saw nominal tax revenues actually rising 2 percent in 1991, but that compares to rises of revenue of 9 to 10 percent in the two years prior. Compare that with the wake of the tech bust of 2000 to 2002, when nominal tax revenues fell for three years running from 2001 to 2003 by a total of 12.3 percent, despite a nominal economy that continued to grow. The 2008 nominal US tax revenues did not recover to a new high until 2013. 

The 2022 US budget deficit is forecast to only reach -4.5 percent of GDP this year and maybe even less, up from a projected -6 percent at the beginning of the year. The fiscal turnaround is so vast that the US Treasury may even reduce the size of some of its treasury auctions this year, helping offset some of the pressure on the market to absorb treasury issuance as the Fed actively reduces its balance sheet at a rising pace until reaching $95B/month in September.  

But the pandemic-era asset market returns ginned up by maximum monetary and fiscal policy support were a one-off that are not set for a repeat any time soon, as both the Fed and the Treasury tighten their collective belts to rein in inflation. So even without a recession, assuming at best that US asset markets trade sideways to slightly up for the rest of this year, next year’s budget balance will deteriorate badly as capital gains tax revenues shrivel and the cost of servicing existing debt skyrockets on all maturing and new Treasury debt resetting to sharply higher yields. Throw in an eventual recession sometime next year and the US Treasury will be in trouble, challenged to fund its spending priorities. In all likelihood, due to the lack of investment to improve the supply side of the economy, inflation won’t have fallen much by then and won’t allow the Fed to ease as forcefully as it has in the recent cycles since 2000. At the risk of getting ahead of ourselves, we will have to consider the next recession policy response. And in that environment, the Fed may be sidelined as the US Treasury reaches for stronger medicine. An example would be implementing capital controls to keep savings at home and/or financial repression through forcing a percentage of private savings into US treasuries that offer savers negative real yields because of caps on nominal treasury yields. In other words, monetary policy is rapidly becoming irrelevant as it can’t keep up with inflation risks. If it did, it would challenge the stability of the sovereign. To watch the Fed is to look in the rear-view mirror. 


The G10 roundup 

FX volatility climbed to its highest level since early 2020 in Q2 of this year, with some remarkable performance divergences in G10 FX. The chief development was the surge in the US dollar on the violent repricing of the pace of Fed tightening and the weakness of the Japanese yen as the Bank of Japan (BOJ) refuses to budge on its yield curve control (YCC) policy, transmitting all of the pressure that normally would have been applied to Japanese government bonds (JGBs) to the yen itself. (See Charu’s excellent article in this outlook that breaks down the mounting pressure on the Japanese yen and BOJ policy.)  

Another subplot worth noting as the quarter wore on is the fading Aussie strength toward the end of the quarter, despite a massive jump in RBA hiking intentions, as the market frets the fall-off in industrial metal prices and China’s intentions for the coming winter due to its zero Covid policy and the risk of further shutdowns in the country. Elsewhere, even commodity currencies were limping into the end of Q2 on likely premature concerns of an eventual recession and/or due to tightening financial conditions, which weigh on a currency like CAD, even if the Bank of Canada is expected to match the pace of Fed hikes. The oil price is north of $110/barrel and Canada is rapidly on its way to clawing back its current account surplus status after the GFC sent it tumbling deep into external deficit mode for more than a decade.  
 
Last quarter, we were far too early in trying to predict a euro recovery, a view that was motivated too much by the hope that the war in Ukraine would wind down quickly, taking the excess pressure off the EU from divergently high power and gas prices. Also, while the European Central Bank (ECB) tried to move ever so cautiously toward policy tightening, it was stunning to see how quickly the bank touted the need to suppress peripheral spreads by shifting its balance sheet holdings at the same time it was supposedly set to exit the negative rate era. The ECB will lag behind everyone, save for the BOJ. The euro will have a hard time rebounding if Chinese demand for its exports remains sidelined, the war in Ukraine grinds on and the US tightening on global liquidity continues. The sterling is in the same boat, and it remains difficult to conjure an upside scenario for that currency, given the country’s extreme supply side limitations and the enormous external deficits aggravated by high import prices for energy. At least the Bank of England continues to talk tough and can hike rates more easily than the ECB. In GBPUSD, watch the enormous 1.2000 chart level after it was challenged in June.  

Finally, there was the shock 50-bps hike from the Swiss National Bank (SNB) at its June meeting that shifted the narrative on the Swiss franc, suggesting the SNB is now less concerned with always lagging behind the ECB in its policy moves and a moderating of exchange rate concerns, at least on the CHF level versus EUR. After all, a strong franc is one tool that can help ease inflationary pressures after the core Swiss consumer price index (CPI) surged to 1.7 percent in May, its highest in decades, save for a single month in 2008. EURCHF reset lower to sub-1.0200 levels after trading between 1.04 and 1.05 before the SNB meeting. Watch parity there for how tolerant the SNB remains for a stronger franc. 
Source: Bloomberg

Special focus: CNH, and especially CNHJPY, likely to command our attention before year-end 

We noted in the Q2 update that the seemingly managed USDCNH exchange rate, under which China allowed its currency to closely track the performance of the US dollar even as the latter soared versus the Japanese yen, was taking the CNHJPY exchange rate to its highest since 2015. This creates enormous tension in the region, as Japan’s exports become far more competitive. (Yes, as Charu wisely points out in her piece on the Bank of Japan and the JPY, this argument has its limitations because so much of Japanese production now is sourced from all over Asia, including China.) It was around the time that the CNHJPY level reached 20.00 back in 2015 that China executed a major overhaul of its exchange rate regime. It is likely no coincidence that it was also on the very day after this exchange rate hit 20.00 this year that China engineered significant volatility in the USDCNH rate by allowing the latter to break firmly above its former, very tight range. As of this writing, the Bank of Japan has just dug in its heels on maintaining the YCC at its 17 June meeting and the CNHJPY rate has traded just above the intraday high of 20.17 from March. Previously, we predicted that China would only move to weaken its currency if inflationary risks were fading, which would require a significant drop in commodity prices. Regardless, CNH could prove the most important currency to watch as a significant potential new source of market volatility if China makes a move to weaken it this quarter or the next—possibly also helping set up the end of a stronger US dollar.

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