Will the Dollar dictate the future path of Fed policy?

Is an inflection point in the dollar index upon us where the March 2015 top marks the end of a cycle high or is this merely a correction in what could be an ongoing long term bull trend?  What would either scenario mean for the global economy?  How will this affect the Fed's ability to lift short term policy rates off the dreaded zero lower bound?

Before moving forward, it's important to acknowledge the limitations of using market prices to answer such questions.  Here is an excerpt from a FRBSF Economic Letter from April - Optimal Policy and Market-Based Expectations:

"Financial market prices contain valuable information about investors’ views regarding future interest rates, inflation, and other economic variables. However, such market-based expectations can be hard to interpret because changes in risk and liquidity premiums also affect asset prices. In practice, policymakers should be cautious in relying on the expectations information in market prices."

The letter points out that using market prices to derive implied expectations is limited given that they only express the views of market participants, especially those of the largest institutional player as well as central banks.  Not all households are represented.  Moreover, the incompleteness of markets as well as their liquidity conditions are both factors that may interfere with policymaker's ability to take market based expectations at face value.  Most importantly, shifts in market sentiment can cause prices to change in a way that are not justified by fundamentals.

"Large flows out of equities and into bonds during “risk-off” phases—when flight-to-safety demand pushes up the prices of safer assets—seem to alternate with flows in the opposite direction during “risk-on” phases when investors’ appetite for risk improves. These changes in market sentiment, which can be viewed as exaggerated or even potentially irrational, are a key source of volatility in financial markets that policymakers may wish to avoid reacting to."

Even in an age of HFT and other automated trading strategies, financial markets still rely on an imperfect collection of human beings to "correctly" price securities in a way that would suggest that they somewhat accurately reflect probabilities associated with an array of possible future states of the world.  Factor in that certain pricing models attempt to quantify uncertainty as if it were the same as risk and market decisions can be quite flawed on these grounds as well.  Finally, career risk associated with fighting a trend too long can cause asset managers to rationally (from an individual perspective) herd given that not doing so may result in individual underperformance and personal ruin. Given how incentives in compensation are structured in the financial industry (benchmarking), it's understandable that such a preoccupation with the need to outperform can lead to this tendency to herd which risks producing crowded trades.  This is made worse when leverage is used.  Such trades can exaggerate price movements in a way that will almost guarantee (in hindsight) that financial assets will not be able to meet the return expectations of market participants.  Therefore, market price trends may reflect financial conditions which at best may be with us only temporarily.  Although I'm sympathetic toward those warning about a potential lack of market liquidity, critics are quick to point to reasons as to why this may be that do not duly appreciate the very human elements described above.  

When it becomes impossible to ignore that actual outcomes are failing to confirm overly optimistic expectations, it should be expected that a lack of liquidity will result when crowded trades are reverse and asset prices fall.  Someone has to hold the bag even if no one wants to.  Blaming central banks, post-crisis financial regulations, as well as other rationalizations feel like a convenient way of justifying the inherent or age-old human tendency to copy one another's actions when faced with uncertainty and the possibility of personal gain or ruin.  As Keynes observed:

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Given how problematic but useful market signals can be, from the Fed's perspective it may be best to listen to markets as one would a radio, a medium used to inform them, rather than listening to markets as you would your mother, as an authority.  This assumes that the Fed would want to avoid allowing market participants to dictate monetary policy.  Even then, passively listening to market price trends can be problematic because markets, much like radios, can be quite noisy and prone to bias.

With that said, the act of interpreting and understanding what markets may be trying to communicate allows the Fed to assimilate an array of views into their own in hopes that it will help them produce the best and most timely policy decisions.  As we have witnessed, not listening to markets can lead to some very ideologically driven policy decisions that are nonsensical given the ongoing economic circumstances.  One only needs to look at the misconduct of a group of US fiscal policymakers who have yet to come to terms with historically low Treasury rates in a world of lowflation.

So after careful consideration and warning, let's look at the charts!
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The Dollar, US Treasury Rates, the Euro, and the Yen



As shown, the dollar index put in what may turn out to be a secular bottom in Q1 2008 which was retested in late 2009 and then again in 2011 before powerfully rallying in mid 2014.  The question that needs answering is whether the price action since March 2015 is carving out a top that will result in the resumption of the old secular trend downward in the dollar or instead if this is nothing more than a correction in a long term dollar bull market.

Without implying causation, the following charts only modestly attempt to show that the dollar's rise has coincided with important financial and economic variables that inevitably may end up influence policy decisions especially among the world's central bankers.

By inverting the US Dollar Index, it's easy to see that its rise coincided with a decline in the 10-year Treasury rate.  Furthermore the drop in the 10-year rate relative to the 5-year, which marks an outperformance by longer dated T-securities, occurred as the dollar broke out.  Interestingly, a fall (rise) in 30-year yield seems to occur whenever the spread between the 5-year yield (rises) relative to the 2-year compresses.  A conclusion then is that a flattening (widening) of the yield curve occurs whenever the dollar FX rate climbs (declines).

To understand why this may be, let's refer to Bernanke's blog post on the term premium:

"Two possible explanations for the recent moves come to mind. First, during 2014, economic weakness outside the US, especially in Europe, increased the expectation of additional quantitative easing abroad. In January 2015 the European Central Bank did indeed announce a substantial program of securities purchases. The anticipation of these purchases, together with the ongoing central bank purchases in Japan and elsewhere, may be "spilling over" into the demand for US Treasuries, pushing down their term premium. Second, the surprising decline in the price of oil occurred at about the same time as the decline in longer-term yields. Falling oil prices may have reduced investors' perception of longer-term inflation risk while also signaling weakness in the global economy."

If we look at the sequence of events beginning in June 2014, the ECB responded to weakness in the Eurozone by instituting a negative deposit rate.  During that time, the Fed was preparing market participants for the end of QE3 which concluded in October of that year.  The Fed would then go on to slightly alter the language in their statements to introduce the possibility that they would commence targeting higher short-term policy rates as the domestic economy improves (data dependence).  As Bernanke mentions, in January the ECB then announced their (convoluted) version of large scale asset purchases that began in March of this year.  So it was clear that US economic strength and Eurozone weakness would result in divergent policy stances, expectations, and interest rates.

BLUE: Real interest rate differential between EZ safe haven German Bunds and US Treasury Bonds

If the above narrative is accurate, then the fall in the Euro relative to the Dollar shouldn't be a surprise as German real rates declined relative to US real rates.  This divergence provided the incentive for capital to flow from Europe to the US as traders, asset managers, as well as corporations looked to issue debt (borrow) denominated in Euros in order to purchase higher yielding dollar assets resulting in rise in the dollar and long term US Treasury securities.  The ECB's introduction of negative interest rate policy proved to be a catalyst for the dollar's near vertical rise that also began in June 2014.

The BOJ with the intention of also fighting economic weakness that they believe is causing Japanese inflation and inflation expectations to routinely come in below levels which they deem desirable have undertaken multiple rounds of CB balance sheet expansion as well.  The Yen's depreciation seems to have created the same impulse that has spilled over into US LT Treasury securities, flattening the yield curve in the process.
Given that both the ECB and BOJ as well as a plethora of emerging market central banks have eased their policy stances at a time when the Fed has been introducing expectations that US monetary policy could tighten sooner rather than later, capital flows have been directed toward the US.  This has resulted in a rising dollar and a falling term premium (interest rate spread between long term vs short term US Treasury rates).  Thus, dollar strength coincided with a flattening yield curve.  It's understood that long-term interest rates can be viewed as a series of short-term rates plus a premium where the Fed and expectations concerning domestic monetary policy dominate the short-end.  However, the long-end appears to be heavily influenced by foreign monetary policy and by extension expectations of global growth.  Thus, expected weakness abroad leads to expectations of more accommodative external monetary policy.  

This is transmitted to the US as borrowing costs, especially important for real estate, ease as the long end of the yield curve falls.  As the US is still a net oil importer, a rising dollar also eases conditions by way of lower oil prices (see below).  The hope is that lower prices at the pump plus lower borrowing costs would cause the contribution to US NGDP that derives from domestic sales to improve enough to offset the slowdown in foreign sales.  The US slowdown in the first part of the year suggests that the US economic strength was not enough to offset weakness emanating from the foreign sector.  This points to the difficult of setting domestic policy independent of what is occurring abroad.  This appears to be especially true during a time when US households are still recovering from the financial crisis and recession as they are not in a position to drive global aggregate demand.
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Oil, the Dollar, and Inflation expectations

Although claims of oil oversupply relative to demand is a narrative that should be taken seriously when analyzing the decline in oil prices, analysts should not ignore the dollar's rise that resulted from such contrasting monetary policy stances.  As would be expected, lower oil prices have negatively influenced inflation expectations.  Although Yellen and other members of the Fed have rightfully acknowledged that the decline in oil, energy, and import prices are negatively influencing inflation and inflation expectations, they suggest that such factors are only transitory in nature.  They may be proven correct, but the Fed is implicitly betting that the dollar price action since March 2015 is the continuation of its secular move lower rather than a correction in an ongoing dollar bull market trend.

Although lower oil prices are a boon to oil importing countries, this "easing" of conditions comes at the expense of oil producing nations whose balance sheets have come under stress particularly those that are concentrated in that industry.  This not only amounts to a reallocation of global income away from oil producers, but reverberates across the globe as the recycling of petrodollars into foreign asset and goods markets is disrupted at least until total oil export revenues recover.  A great example of what can result when a nation is overly dependent on one export is Russia.  Not to make light of Western sanctions, but it seems that the abrupt decline in the price of oil catalyzed the capital flight, currency depreciation, and the foreign reserve drain that has caused great distress to Russia's economic performance.

US TIPS, core inflation, and inflation expectations are closely correlated 
to the performance of dollar denominated EM bond funds.  

As for the US, unfortunately it seems that the decline in oil resulted in an increase in the US savings rates rather than an expansion in US domestic spending (NGDP).  This likely contributed to the weakness in overall economic activity in the first half of the year, particularly if the plight of US oil producers and their affect on US debt markets is taken into account.  With that said if the dollar has at least put in an intermediate term top, then it would be reasonable to assume the oil prices and by extension inflation and inflation expectations have bottomed.  This would not only suggest that the first Fed rate hike may be upon us in late 2015 if not 2016 or that the path of future rate increases may end up being steeper than expected (dot plots), but it points to the idea that a more general reflation of the global economy may be in its infancy.  If the reflation scenario comes to pass, then the deficient demand from abroad may be subsiding or set to as global dollar financial conditions begin to ease especially in a global financial system that has come to more greatly rely on dollar funding.  Much like during QE, a decline in the dollar would coincide with a rise in longer dated t-security yields.  If one views the US as global insurer/global banker where demand for long-term Treasuries represents demand for global insurance, a decline in long term US Treasury bond prices implies that global risk appetite may be on the verge of improving.  This would add fuel to the reflation scenario.    

Obviously, this more optimistic narrative still remains to be seen.  Regardless this suggests that the Fed's ability to tighten monetary policy without disrupting US economic performance is limited by external factors unless domestic economic activity improves enough to offset disappointing sales to the foreign sector.  Although the Fed has expressed that they do not conduct policy on behalf of the rest of the world, it may be imprudent of them to do so in spite of economic conditions found outside the US.  This point is important when one considers how a lack of aggregate demand in the EZ negatively impacts the rest of the world.

(See my follow up post on the Eurzone's imbalances to understand why.)
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Summary:

1.  Beginning in July of 2014, the dollar rally and the decline in LT Treasury yields, the term premium, oil, core inflation, and inflation expectations all at least concurred nicely with the ECB's implementation of a negative deposit rate that sought to respond to EZ economic fragility.

2.  Much like during Fed QE, European interest rates trended downward after the announcement of the ECB's version of large scale asset purchases only to rise sharply as buying began in March.  This is exemplified by the trend in German Bunds that suddenly sold off in April.

3.  Since around March (or Q1) 2015, the dollar has been in correction while US LT Treasury yields, the term premium, oil, core inflation, and inflation expectations have all rebounded.

4.  Yellen has explicitly stressed that the path in which policy rates are likely to take is more important than the liftoff date.  A steeper path implied by the Fed's subsequent dot plots suggests that they expect enough improvement in the data to justify such a stance whereas a flatter path signals the opposite.  Not only will it be interesting to see how these expectations affect the dollar's trend, but also how the dollar's trend will influence these expectations.  If the dollar continues to correct, market participants may attempt to front run the Fed by pushing up LT Treasury yields.  This reflation scenario would give the Fed enough room to raise rates in a way that would not cause the yield curve to flatten.  However, Fed expectations that are overly optimistic may lead to a continuation of the dollar's previous bull trend which in turn could cause data to come in weaker than expected.  Therefore, it may be difficult for the Fed to tighten or even signal such expectations unless global growth, especially in the Eurozone, improves.  Otherwise, they risk setting off a dollar rally that could threaten to sabotage such a stance.  Unfortunately, if this analysis is somewhat correct then it means that the Fed may be at least partially dependent on the ability of Eurozone policymakers to promote sustainable economic activity.  Any disruptions to the region's prospects and Fed policy may be on hold or near zero for longer than they would deem desirable.

5.  If a disruption (Greece) in the EZ does materialize then dollar selling may take hold as market participants begin to expect that such an event would force the Fed to remain on hold or act more passively going forward.  One assumes that the Fed would not want to front-run a potentially contractionary impulse emanating from abroad by tightening prematurely.  Premature tightening would make it more likely that the Fed would have to reverse course if US NGDP, employment, and inflation expectations are negatively affected.  That could signal to markets that things are not well in the global economy and financial markets.  As prior posts have mentioned, the balance between the risks and rewards to tightening seems to be more asymmetric than appreciated since the upside of such a policy shift feels quite limited relative to a rate increase or rate path that may later be deemed a misstep.

6.  Then again such a scenario could create expectations that the ECB may be forced into conducting unconventional monetary policy for longer especially to avoid contagion by limiting the risk of having interest rate spreads blow out in troubled countries.   This would be symptomatic of a flight to safety where capital attempts to move from the periphery to the core in an attempt to avoid redenomination or worse, euro existential risk.  It would be hard to envision the dollar not appreciating under such circumstances.      

If such a scenario is avoided where global reflation is able to take hold then the opposite may hold true, leading to expectations that the ECB could tighten earlier than previously presumed.  At the moment this seems unlikely, but the possibility should be taken into consideration nonetheless.