The Dollar and Treasury Yields in Limbo: Part 2

In the prior post, The Dollar and Treasury Yields in Limbo: Three Possible Scenarios, I explored potential paths for how the global economy and financial markets could proceed in the intermediate term.  The main difference between the three outcomes depended on the market's perception of the Fed's reaction function.  Seeing as the market odds of a June rate hike have increased substantially following the release of the Fed's April meeting minutes, it felt necessary to further examine scenario 2. 

"2).  US growth rebounds relative to the rest of the world

The 10 year yield remains near the current range or breaks below 1.55%.

The dollar either continues to consolidate between $100 and $93 or trades above $100.

• Market participants price in a steeper path for US policy rates going forward by pushing up short-term treasury rates in anticipation of improving US growth or as inflation approaches the Fed's 2% target.
• The Fed allows inflation to bottom but communicates that a period of overshoot is undesirable.  
• The US economy would continue to lead, but decelerating relative growth in the rest of the world results in subdued long-term treasury bond yields.

What to look for:

• The dollar strengthens against a broad basket of currencies
• Short-term treasury rates rise faster than long-term rates
• Inflation expectations bottom but remain within the Fed's comfort zone
• US real rates rise as nominal rates increase relative to inflation
• Credit spreads widen or at least fail to narrow materially
• EM, commodities, and related securities are mixed, range bound, or remain under pressure relative to US securities"

The case for a Fed rate hike sooner than later seems to hinge on the following assumptions.

• Labor market indicators suggest that the US economy is operating close to full potential.  The degree of excess slack has diminished to the point where the nascent wage growth has momentum and is expected to continue. 
• With the output gap closing in the face of improving wage growth, the future path of nominal GDP and inflation will be high enough to allow the Fed to increase short-term policy rates in the intermediate turn without necessarily tightening monetary policy.
• In this optimistic case, if the Fed were to hold off on raising the policy rate in the intermediate term, they could be seen as enabling a passive loosening of monetary policy by allowing reflation to take hold (scenario 1). 
• If the market perceives that the Fed finds an inflation overshoot undesirable (despite missing on their inflation mandate for four years), remaining on hold for now in a potentially reflationary environment can lead to market expectations that the Fed will eventually have to respond by abruptly increasing policy rates in the future.  A potentially destabilizing shift in policy rates may jeopardizes the employment gains produced by the recovery.  Therefore, remaining on hold may prove to be self-defeating.
• A reflation trade where real yields decline for a period of time risks reigniting a damaging rise in commodity and oil prices that may impair US household consumption.
• Consequently, in an inflation targeting monetary regime where undershooting the inflation mandate is deemed acceptable while overshooting is not, in order for the Fed to gradually target higher short-term policy rates they must remain ahead of inflation.

The case against a Fed rate hike sooner than later is as follows.

• The US economy is not operating close to full potential.  After hitting multi-decade lows, the reversal in the downtrend in the civilian labor force participation rate since November may hint that there is still substantial slack in the labor market.  Moreover, the nature of the job creation since the end of the recession has been concentrated in the low-wage sectors of the economy.  A more rapidly improving economy where an expansion of aggregate demand is allowed to manifest itself will increase the labor supply and subdue wage growth in the process.
• Inflation as measured by core PCE has averaged below 1.5% since the end of 2008 and 1.5% since halfway through 2012.  Headline CPI and core CPI have averaged 1% and 1.8% respectively since the beginning of 2013.  It can be argued that during this period the stance of US monetary policy has been too tight especially given the rise in the dollar which has tightened financial conditions in the Eurodollar market.  It's important to envision where the price level and NGDP might have been had the Fed consistently hit the 2% mandate by acting more aggressively during that period.  To not allow catch-up growth now in both variables, the Fed would be permanently accepting a lower level in both NGDP and in the price level than otherwise would have been. 
• To avoid this, a temporary period of reflation where inflation is allowed to drift above 2% becomes desirable.  Although this may cause commodity and oil prices to trade above their recent multi-year lows, prices are unlikely to reach their cycle highs given the presence of on-demand US shale producers and the excess capacity in commodity production more generally.  Therefore, the risks of a commodity price rebound causing an impairment of US household consumption is less likely today particularly if household income growth is allowed to strongly materialize.  Furthermore, the rebound in commodity prices and a fall in the dollar can relax financial conditions in the Eurodollar market as the deleveraging in foreign dollar denominated debt becomes less of a strain on global growth.
• Allowing for an inflation overshoot would require clear communication (a nominal GDP level target) otherwise inflation expectations may become unanchored to the upside.  This argument can leave much to be desired seeing as if the target has been unmoored it's been to the downside since the Fed has missed its inflation target for four years.  It can be debated that the Fed has really been targeting an inflation corridor between 1% and a 2% ceiling.  As long as the Fed is able to clearly communicate that any above target inflation is only to allow for a temporary period of catch-up growth, then they may be able to cautiously remain on hold in the near term while avoiding a steeper policy interest rate path in the future.
• Moreover if above trend inflation does become problematic, the Fed's policy tools are more equip to deal with this issue by increasing short-term policy rates or even shrinking the size of their balance sheet.  On the other hand, if NGDP growth slows undesirably, the Fed very well may confront the dread zero lower bound again.  In the worst case scenario (3. Risk aversion and Panic), the Fed overreacts to the positive developments in the labor market and attempts to remain ahead of inflation by preemptively increasing policy rates only to stifle the weak recovery before it gains sustainable traction.  If such a state of affairs were to occur, doesn't this make the  NIRP, LSAPs/QE, long term treasury rate pegs, helicopter drops (glorified deficit spending via technocratic means), or some combination of these more likely?  Advocates of a rate hike today should find the proposition of those measures to be incredibly disturbing.  Yet front running inflation makes that undesirable reality more likely as long as NGDP fails to reaccelerate.

Ultimately the Fed's next move and market expectations pertaining to the future path of monetary policy will have to be corroborated by nominal GDP growth.  If NGDP growth were to break upward then a rate hike sooner than later will be judged to have been prudent in hindsight.  Targeting higher short-term policy rates does not necessarily constitute a monetary policy tightening as long as NGDP growth improves.  If NGDP decelerates while corporate earnings continue to drop off, then the Fed's monetary policy stance will be seen as having been overly tight especially in the context of a precarious global economic backdrop.

The Technical Picture - A few questions to contemplate

1. If the Eurozone, Japan, China, and emerging markets continue to suffer from slowing or weak growth where this causes market participants to anticipate ongoing policy easing in these major regions, can the Fed increase short-term rates without fueling another leg higher in the dollar against a broad range of currencies (continuation of yield differential trade)?
2. Assuming that another push higher in the dollar triggers a subsequent down move in the commodity complex, would the 10 year treasury yield begin to price in subdued inflation expectations and/or a lower future path of real short-term interest rates?  Wouldn't this induce market participants to expect the Fed to remain on hold after the next rate increase (gradual path)?
3. Suppose US NGDP growth does break upward where the Fed is able to maintain higher short-term rates, could the 10-year treasury yield move up materially solely on the back of stronger US NGDP?  If so, might this be a sign that US NGDP growth is enabling a rebound in global growth and risk taking?
4. Could such a rebound in global growth eventually limit the dollar's rise as the need for foreign central bank easing dissipates and expectations of higher future interest rates outside the US take hold (optimistic outcome)?  
5. If NGDP growth fails to accelerate (or decelerates) while the dollar trends upward as the 10 year yield breaks down, might this signal that US economic activity is unable to offset weak global growth?  If this is the case, shouldn't these conditions restrict the Fed's rate cycle?  In other words, can the Fed unilaterally target durably higher policy rates (real rates) in the absence of a recovery in the ROW particularly in the China, Eurozone, and Japan (pessimistic outcome)?
6. Were the dollar to appreciate against a broad range of currencies in anticipation of a Fed rate hike, how might this affect market expectations pertaining to a Chinese yuan depreciation?  If the PBOC were to maintain the FX rate in the face of capital outflows by selling dollar reserves off their balance sheet, this act tightens financial conditions within the Chinese banking and financial system.  Wouldn't this exacerbate the Chinese slowdown and in turn cause markets to expect that eventually the PBOC may have to expand the RMB monetary base in order to support their fragile internal financial situation even if this resulted in a depreciating currency?  Then again, one imagines that such a situation should force the Fed to reconsider its plans for the future path of monetary policy.  If so, then isn't the Fed constrained in how they can maneuver?  What would that mean for the dollar?