The US Federal Reserve is playing catch-up with market expectations for rate cuts. But if we see further signs of a US growth slowdown from here, the Fed will quickly axe rates to the effective zero bound and could even restart quantitative easing before year-end. But it’s not just a dovish Fed that will see the USD turning lower in the second half of 2019.
Historically, US Federal Reserve easing cycles have coincided with a strong dollar as global deleveraging prompts the global financial markets to scramble for USD funding. This time around, we may have already seen the maximum potential for USD strength early in the Fed’s shift to a more dovish stance, and the USD looks set to weaken if the Fed keeps delivering powerful easing and the rest of the world wakes up to the potential for fiscal policy options.
The most remarkable development in currencies over the first several months of 2019 was the resilience of the US dollar despite the whiplash-inducing reversal in Fed expectations, from hawkish in late to December to dovish and then more dovish with each subsequent Fed appearance in 2019. This shows how far the Fed overreached during the later phase of the tightening cycle in 2018. Kicking off the view to the third quarter and beyond, at the June 19 Federal Open Market Committee meeting, the market felt that it got the signal from the Fed it needed to continue pricing for aggressive further easing.
And given the risks of a growth slowdown in the US already baked into the cake, from the weak credit impulse to the rolling off of the impact of Trump’s tax reforms, we should expect clearer signs of a weaker US economy to emerge.
As the second quarter draws to a close, one sign that the Fed is still playing catch-up is the still rather flat yield curve, where the two-ten slope has yet to steepen notably even after the market had already priced the next 100 basis points of easing for the coming 12 months. The market is far too cautious in that regard. If we see material signs of weakening in the third quarter, the Fed will chop to the effective zero bound at a breath-taking clip and could even restart quantitative easing before year-end.
For the second half of 2019 we will be looking for a transition to a weaker US dollar as the Fed is set to deliver strong easing. And if it doesn’t, it will be so rapidly disciplined by the market that it will be forced into so doing. (That was what the December market meltdown and subsequent implicit Fed mea culpa was about, let’s recall.) But as Steen Jakobsen writes in the introduction to this outlook, Fed rate cuts and restarting the same old QE playbook are pushing on a policy string. The next and more powerful policy drug is fiscal, a Modern Monetary Theory framework of proper fiscal helicopter money spending, not the pointless purchase of safe treasury assets that drives savers out the risk-taking curve. Whether the US can make a quick transition to MMT will depend on whether US President Donald Trump is able to make a truce with the Democratic House of Representatives, both in general and on ceasing and desisting on impeachment efforts. An ugly standoff could slow the transition to a weaker USD.
The collapsing rate outlook from the Fed and its willingness to bring back the policy punchbowl will make the rest of the world look less bad, though there are residual risks that any ugly episodes of general market deleveraging could drive bouts of USD (and, maybe even more so, EUR and JPY) strength against the most vulnerable currencies, the Turkish lira, for example. Elsewhere, the world doesn’t look great, but the lack of room to move further on the monetary-policy front will encourage a more rapid transition to fiscal policy options. Surely countries like Australia, where the market is already projecting that the Reserve Bank of Australia will take the policy rate below 1.00% later this year, can learn the lesson that has been so glaring over the last ten years. Zero interest-rate policy, negative interest-rate policy and quantitative easing are a swamp from which policymakers will never emerge if those are their only policy options.
And while a shift to MMT and a fiscal approach in the US is potentially highly negative for the USD, as the US already has the world’s largest deficit, it could be positive for other currencies where capital has been fleeing due to punitive low interest rates and where austerity has kept monetary growth very low. The starting point is very different, after all, with the US already with an annual trillion-dollar budget deficit run-rate that will only yawn wider while other countries have run surpluses in recent years.
Take a country like Sweden, which has a seemingly permanent current account surplus and has seen its currency in a negative spiral since the 2013 highs as rates were taken to deeply negative levels to avoid deflation. The combination of easy monetary policy and tight fiscal policy in recent years is a poisonous cocktail for a currency. By opening up for fiscal stimulus, perhaps combined with supply-side tax cuts, Sweden would see capital both stay at home and rush back home to invest. Besides, the country needs to invest in housing and other infrastructure to accommodate its massive influx of immigrants and refugees in recent years.
Most refreshingly for currency trades, the second half of this year brings the likelihood of a multi-speed world in which some policymakers are slow to see the light while others forge aggressively ahead. Policy divergence is often a powerful market mover, so we could also see an end to the incredibly low volatility in FX that has marked the last couple of quarters. And that dynamism in exchange rates will, in some cases, also serve to hasten the next policy response – especially in Japan. In short, buckle up, because things are about to get interesting again.
Select currency comments
USD – the Fed appears set to deliver powerful easing; it just needs to remain powerful enough to outpace the offshore USD liquidity risks that can develop during risk deleveraging events. A deglobalising world, the US’ increasing weaponisation of the USD and its power over the global financial system, together with President Trump’s tilt away from multilateral international institutions will have the world scrambling to reduce exposure to the greenback.
EUR – the European Union is in most need of a switch to an MMT framework if the whole stumbling EU project is to avoid existential strain, especially Italian deputy prime minister Matteo Salvini’s mini-BOT alternative currency scheme. The EU stands to gain the most, both economically and in exchange-rate terms, from a more generous fiscal response, and even if the next European Central Bank president is the German Jens Weidmann, he has declared that Outright Monetary Transactions (essentially MMT) is a valid policy option (and declared legal by the key EU courts.)
JPY – strengthening pressures have appeared as US yields collapse. Watch for Bank of Japan governor Haruhiko Kuroda and prime minister Shinzo Abe to bring out the next policy bazooka if USDJPY threatens below 100.00.
CHF – a switch to a fiscal approach in Europe could slow the Swiss franc’s ascent, but certainly we can also expect the Swiss National Bank to push back hard if the trade-weighted franc rises from here.
GBP – we are constructive on sterling for the medium term. It is cheap, the country has moved away from its austerity posture, and in the end, we expect common sense to prevail and that prime minister Boris Johnson and the EU agree on a “managed Brexit,” perhaps with a year or more to hammer out a trade deal after the October 31 exit date.
Smaller DM currencies – some downside risks here as all five G10 smalls have housing bubbles to contend with, but the starting point is already generally low. SEK looks one of the cheapest, while AUD could suffer some further broad weakness before bottoming out as Australia’s housing bubble risks a major dent to the banking system and consumption, though its much stronger current account fundamentals are already softening the downside risks.
EM – the surplus countries exposed to China may suffer short term, but China tends to lead the global economy, so these could pivot back to strength first as China’s economy bottoms first and begins to rise again. The bellwether is the Korean won. Elsewhere, the vulnerable EM countries that run current account deficits will need to hope that the Fed easing remains powerful enough to offset risks from foreign-denominated debt loads.