Is this a case of Dollar Déjà vu?

From the September post,

With that said, the dollar's role is the dominant factor in the FX markets as expectations pertaining to the path of Fed policy and by extension real interest rate differentials both influence proceedings globally.  As markets begin to strongly anticipate at least one rate hike in the final months of 2016, it may be worth revisiting the price action in the US treasury bond and FX markets that occurred prior to the December 2015 hike.  By October 2015, treasury bonds began to sell off violently as the dollar started to surge against a broad range of currencies.  Although the dollar and the treasury rate rise eventually did reverse while risk assets bounced back for much of 2016 (see February, May, May market commentaries), as mentioned too many times already (apologies) the troubling deceleration in NGDP and RGDP has not.

Short term analysis: US dollar and treasury yields

Although it certainly can be argued that the Trump shock has influenced the US dollar and treasury yields, both had bottomed and already begun their ascent prior to the surprise election results.  By this September markets had started to strongly anticipate a Fed rate hike in the same way they had going into last year's December decision.  The dollar index hit a low at the bottom of its multiyear year range in August 2015, consolidated, and then rallied from October into December 2015.  Longer dated treasury yields exhibited similar price action as the dollar. 

If one fasts forward a few months later, the dollar and treasury rates have repeated this pattern by bottomed this past summer, consolidating, and then rallying ever since.  Therefore at least initially much of the price behaviors in both can be attributed to market participants anticipating the Fed's next move.  What is yet to be known is how markets will react once the news of the Fed's rate hike have been announced along with their forward guidance.  One will be in a much better position to disentangle the Trump effect from the Fed's influence once this is known.  If the gains in the dollar and treasury bond sell off prove durable this time, that would serve as the strongest signal that market participants are pricing in the potential for a regime change* where fiscal policy begins to play a larger role than Fed fine tuning in driving growth.

With that said, there are clear distinctions that suggest that this macro environment is clearly different than last year's; none more evident than credit spreads.  By the end of 2015 high yield credit spread lead by the energy sector were blowing out, whereas this year they have narrowed considerably.  Although global financial stocks did appreciate into December 2015 as the 10 years treasury rate was rising, this recent explosive move to the upside in financials has been far more pronounced.  US equity indices were close to testing new highs by December 2015, yet they have already forcefully broken through that barrier heading into this December announcement.  Moreover, market based inflation expectations appear to have broken out to the upside as well.  At the very least, this all suggests that markets are pricing in the expectation that the headwinds that have negatively affected US economic activity are firmly in the past.

Hypothetical longer term view:

As David Beckworth succinctly explains:

the Fed has been stuck in a seemingly endless rate-hike-talk-loop-cycle in 2016. The cycle goes something like this: the Fed talks up interest rate hikes → dollar begins to strengthen → bad economic news emerges → the Fed dials down its rate hike talk → dollar pressures ease → good economic news emerges → repeat cycle. This cycle occurs because one, there is approximately $10 trillion in dollar-denominated debt outside the United States per the BIS and two, because many countries still peg to the dollar. A strengthening dollar is a problem for the former since implies a higher debt burden while for the latter it means pegging countries have to import the Fed's tightening of monetary policy. Most Fed officials, other than Governor Lael Brainard, fail to fully appreciate this loop.

The global concerns highlighted above could be set to flare up in a much more acute way as the dollar's pause may be poised to end as its uptrend reasserts itself in the coming months.  To put this cyclical dollar strength into perspective, observe the following long term chart:

Since the mid-1980s, the dollar has experienced three powerful cyclical uptrends (dollar surge during financial crisis was a much more acute risk-off move).  Seeing as the 1980s dollar and interest rate complex ushered in a period of secular disinflation and falling rates, this recent period of dollar strength seems to more closely resemble the price action exhibited in the 1990s.  Bear in mind the similarities should only be taken so far especially considering this exercise may be another case of a human being looking for patterns where none really exist! 

• In both instances the greenback tested and held a prior low (1995 successfully held 1992 bottom, 2011 successfully held 2008) before beginning a multiyear uptrend. 
• During this phase, longer dated treasury yields initially rose abruptly on at least two occasions (1994 and 1996, 2009 and 2013).
• Once the dollar's uptrend was firmly in place, treasury yields fell only to stop doing so after the dollar made a temporary top in a period of sideways consolidation.  In each instance (1998 & 2016), treasury yields hit generational lows. 
• The dollar was trendless between mid 1997-1999 and 2015-2017(?).  In the meantime, treasury yields rebounded (October 1998- January 2000, July 2016 - 2017?) forcefully during the USD's sideways period.
• In 2000 when the USD's trendless period gave way to a continuation of the prior uptrend, treasury yields fell precipitously.  During the dollar's final blow-off top of Q4 2001- Q1 2002, yields briefly jumped only to collapse to multi-decade lows soon after.  This time the USD fell sharply as well reversing seven years of appreciation in just three years.
• If these similarities do in fact exist and are not simply coincidental, that would indicate that today's price action is similar to that of roughly 1998/1999.  This turned out to be a late cycle/stage financial environment.

A few parallels and possible insights:

• US nominal GDP experienced a late cycle pick up from the end of 1998 until mid-2000.
• The oil bear market that began in 1997 saw prices collapse nearly 60% by Q4 1998.  Oil then tripled in price by 2000.
• The Effective Fed Funds rate followed oil's two year climb.
• By November/December 1998, the major US equity indices were all breaking out to the upside making all-time highs.
• US high yield credit spreads narrowed in a similar fashion as they have today.
• The transmission of US monetary policy via the dollar's influence on the FX markets and global financial conditions proved to be quite powerful.  The greenback's rise coincided with the 1997 Asian financial crisis, 1998 Russian financial crisis, and the Argentine economic crisis 1999-2002.  With the buildup of foreign dollar credit that has occurred since the GFC, should the global financial turmoil witnessed during the end of 1990s/early 2000s serve as a warning?

Conclusion:

With the Fed set to announce their second rate increase of the post-GFC world, it still remains to be seen how markets will trade following such news.  Will the fall out more closely align with what occur in the first half of 2016 when the dollar and yields sold off in a risk off mood in the weeks following Yellen's announcement?  Although the risk aversion and market volatility experienced at the time dissipated as the year dragged on, that is arguably due to the fact that the Fed was forced to back off their initially advertised rate path.  In essence the Fed ended up having to move closer to the market's more subdued policy rate expectations.

On the other hand, does this present financial environment more closely mirror a late cycle US nominal GDP growth pick up similar to what occurred toward the end of the 1990s?  If so, does it become more likely that the Fed will actively seek to readjust their rate projections to the upside as the year wears on?  Judging by the Fed's past reaction function, if nominal GDP growth were to revive with inflation approaching target (particularly if oil prices were to rise materially), it's doubtful that the Fed would support an overshoot.  Therefore, in such a scenario the Fed's unwillingness to allow for a brief period of above trend inflation despite routinely missing their inflation target could potentially lead to the dollar's next leg higher.  A Trump fiscal expansion may at least temporarily offset higher private sector borrowing costs and in doing so support domestic aggregate demand.  However, a US fiscal expansion may not prove forceful enough to accommodate the rest of a world if a rapidly rising dollar were to considerably tighten global dollar financial conditions.  As has been the case, interest rate differentials and carry trading are still the main drivers of the dollar's trend.  If the late 1990s-early 2000s does prove to be a useful comparison, it perhaps should serve as a warning that a period of prolong dollar strength eventually risks derailing the US economy. 

Thus, a surging dollar may require monetary and fiscal easing simultaneously.  Otherwise the expectation of expansionary fiscal policy carries with it the possibility of excessive monetary tightening that risks undermining the reflation trade if the dollar's run gets out of hand.  A dollar squeeze accompanied by rising long term offshore dollar interest rates suggest that global markets anticipate that affordable dollar funding will be less available on a continuous short term basis (dollar shortage).  In a world with an elevated level of dollar denominated foreign debt (EM corporates), the global system's diminished capacity to recycle dollar funding on top of Trump's protectionist rhetoric (if carried out) could prove to be a lethal combination.  Ironically widening interest rate differentials between the US and other developed economies as a result of the Fed's reaction to rebounding US NGDP should lead to a larger current account/trade deficit to match the capital inflows into the US.  Therefore a powerful dollar breakout could prove to be a destabilizing force that threatens the Fed and Trump's credibility if US economic growth isn't forceful enough to power global economic activity.***

Also see:

• The questions found at the end of this May 2016 post as they pertain to the above conclusion.
• This post on China's impossible trinity in the context of a rising USD.

As the US vs Euro interest rate spread widens, the dollar strengthens

Although global financial equities have rallied, Chinese financials have badly lagged.  A sign of stress amid capital outflows (see here)?

*From Part 2: Accommodating private sector savings and NGDP growth

Thus, it becomes imperative for private and public sector behaviors to adjust course first beforehand*.  Until that occurs, our low interest rate world will persist for the foreseeable future.  Problematically, the expectation that the economic malaise is likely to continue is self-reinforcing given that present and planned behaviors are dictated by our thoughts about the future.  Planned private investment is a function of future profitability on new projects, planned household consumption spending is a function of future expected income growth and job opportunities, and importantly lending is a function of both.  What then is required is a strong commitment to collective action (fiscal monetary cooperation toward the maintenance of a predictable NGDP level path) that seeks to permanently change our views about the future.

**The bank/capital markets nexus goes global:

One lesson from the Great Deleveraging of 2008 was the futility of drawing a clear distinction between banks and capital markets when wholesale funding was the margin of adjustment. In 2008, leverage and risk appetite danced to the tune of the VIX index, and a generation of researchers grew up with the VIX index as a “wonder variable” in empirical research. But the mantle of the wonder variable has slipped; the VIX index no longer works as a barometer of risk appetite. Instead, it is the US dollar which has taken on the mantle of the market risk factor. When the dollar is strong, risk appetite is weak, and market anomalies such as the breakdown of covered interest parity (CIP) become more pronounced.

***Unless growth prospects improve in the rest of the world, depressed interest rates will lead to weakening currencies and capital outflows.  The other side of this trade is dollar strength.  Moreover, US imports are a function of US nominal aggregate demand while US exports are a function of global aggregate demand.  Consequently, a period of prolonged US NGDP growth relative to the ROW corresponds with a deteriorating trade balance as foreign entities attempt to accumulate dollar income by reducing their pace of spending on imports.  However, if a US nominal aggregate demand pick up proves forceful enough to carry the ROW, this global growth driver may regenerate global economic activity to the point where foreign entities are no longer strained financially.  This ideal scenario seems unlikely given the Fed's unwillingness to tolerate a high powered US economy on top of a Republican congress that probably will not tolerate such a degree of fiscal expansion.