Trump vs. the Fed & USD

China, the European Union and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates while the dollars gets stronger and stronger with each passing day - taking away our big competitive edge. As usual, not a level playing field...

— Donald J. Trump (@realDonaldTrump) July 20, 2018

Is Donald Trump justified in his complaints concerning the path for policy rates in the United States?  Yes and no.  Are Donald Trump's comments an accurate and fair reflection of what is going on in the foreign exchange markets?  In the humble opinion of this blog, no they are not.

Before even trying to explore such questions, it is important to acknowledge the current trends.

• The Fed Funds rate has moved from under .15% before the first Fed rate hike in December 2015 to 1.91% which is within the Fed's range of 1.75% & 2%.
• During this time the two year treasury rate rose from .91% to roughly 2.67% at present.
• Following the July 2016 Brexit bottom, 10 year treasury yields rebounded from 1.91% to reach highs above 3% as recently as May 2018.
• From the end of 2014 to the beginning of 2015, the USD has been in a wide multi-year trading range.  The greenback hit cyclical highs in January 2017 followed by fresh lows approximately one year later.  Since the Q1 2018 nadir, the dollar has staged a mutli-month rally that has allowed its price to make a 52 week high.
  
• Most importantly, US nominal GDP growth (total spending on US domestically produced goods and services aka aggregate demand) had been decelerated markedly heading into the acute global risk off phase of early 2016.  Fortunately, market pessimism concerning the health of the Chinese economy (emerging market prospects in general), commodity complex (particularly oil), flagging US, European, UK (Brexit), & Japanese growth, gave way to renewed optimism.  As dire as the first half of 2016 appeared, the Fed responded by essentially postponing the 2nd rate hike for much of 2016 while the other major central banks engaged in their forms of balance sheet expansion.  Markets also began to anticipate looser fiscal policy under a Trump presidency upon his electoral victory.  All this has worked to push US NGDP growth from a post-GFC low of 2.3% (Q2 2016) to 5.39% registered for Q2 2018.
  

Why are US interest rates rising along the yield curve?

It's unquestionable that the Fed exerts far greater influence on the front end of the yield curve as market participants bid up short-term treasury rates in anticipation of the Fed's desire to tighten monetary policy.  Unlike short rates, the long-end of the treasury curve is governed by the nominal growth (inflation plus aggregate output) expectations.  Whenever total spending on domestically produced goods and services accelerates, it should come as no surprise that long-term yields tend to follow along by moving higher.  At present, US nominal (year-over-year) growth is the strongest it has been since recovering from the global crisis and long-term treasury yields have responded accordingly.  Thus, on NGDP grounds, it is hard to argue that the current stance of monetary policy is overly restrictive given today's domestic conditions.  Therefore, in this sense Trump's criticism of the Fed's recent performance (especially as of 2016) is unwarranted.

However, this does not suggest that it can't be argued that the Fed has been too tight seeing as inflation has remained subdued after years of the central bank missing its 2% target.  Although core PCE (chained price) recently hit the 2% inflation objective this past May, this measure has averaged 1.6% over the last 5 and 10 years.  This overall inflation picture suggest that the Fed could justify allowing the economy to continue to strengthen in order to push the long term inflation average up to target especially if this avoids inverting the yield curve.  

So Trump's US monetary policy concerns aren't totally misplaced.  Now, if the Fed were to communicate that they were increasingly willing to allow NGDP to further accelerate (enabling unemployment to fall further as inflation moves closer to target) by signaling a slower pace of tightening, this increases the chances that long-term treasury yields will keep trending higher as inflation and growth expectations improve.  With all that said, it's unlikely that the Fed will change course unless nominal GDP growth slows materially.

What is the cause of the dollar's recent strength?  Are foreign central banks purposely depreciating their currency exchange rates?

As highlighted above, the US dollar has staged a 2018 relief rally that has returned its price to the midpoint of the multi-year range (2014/15 - present).  With history as the guide, the February 2018 blog post warned to keep a careful eye on the dollar because turbulence in global risk assets, commodities, and emerging market currencies tend to occur whenever the USD strengthens.  This recent episode of dollar appreciation has matched past periods.  Since the January dollar bottom, US equity indices have moved in a sideways consolidation, oil's uptrend has been checked, and emerging market assets and currencies have sold off.  In essence, a strong dollar usually coincides with lackluster returns on risk assets and that has been the case thus far in the first half of 2018.

During periods of risk aversion or downright panic, investor pessimism results in the bidding up of safe assets relative to risky ones.  In these instances market participants have sought the safety of the USD assets particularly in the form of treasury bonds.  Consequently, such  panics cause investors to bid up the dollar exchange rate as treasury yields decline.  Thankfully, this combination is not present today seeing as treasury yields are near multi-year highs.  Therefore, until treasury yields start to trend lower signaling deteriorating inflation and growth expectations, the greenback's trend likely has more to do with improving nominal growth expectations in the US relative to the rest of the world following Trump's fiscal expansion via tax cuts (positive for US) and trade tensions (negative for global growth).  This story is supported by the fact that US equities have outperformed their foreign counterparts since the start of the year despite temporarily peaking in Q1.*

This is why assigning blame on foreign policymakers for the dollar's recent strength is a gross misrepresentation given how difficult it is for foreign central banks to prevent their FX rates from depreciating against the dollar when pressured by capital/portfolio outflows.  If anything, much like past episodes of dollar appreciation, foreign policymakers have taken measures to prevent their FX rates from falling further had market forces fully had their way.  Thus, in the event that foreign CBs have been "manipulating" their currencies, it has been by trying to stop a disorderly depreciation and not by forcing their currencies lower.  Ironically, if Trump had his way where foreign central banks were to get ahead of their recoveries by tightening their monetary conditions, this risks causing their respective economic growth rates to disappoint and long term interest rates to fall (see the 2011 Eurozone Crisis & 2016 China scare).  It goes without saying that such a scenario would exacerbate the dollar's up move as global investors seek the safety of dollar risk free assets.

Concluding Remarks:

Considering all the above, it is unlikely that the dollar uptrend reverses until one or more of the following occurs:

1. The Fed signals that they are willing to allow the US economy to run hot by slowing their pace of rate hikes.
2. Foreign policymakers do more to improve their economy's outlooks in the minds of global fund managers by pursuing policies that are expected to expand output growth and aggregate demand.
3. The Trump administration is less combative over trade issues which are clouding the forecast for global growth going forward.  
4. The USD's uptrend burns out & reverses due to other psychological/technical reasons in the minds of trader/investors.  Since the dollar's trend can be viewed as a way of gauging risk sentiment, renewed confidence in the global economy very well could halt the current advancement in the favored reserve currency.  This was the case for much of 2017 where market participants rushed into emerging market assets because of the optimism in the global growth story.  For now, as the dollar continues higher it should be expected that foreign risk assets will remain under pressure.  

*A very short version of this post:

Faster expected US NGDP growth relative to the rest of the world (in part due to tax cuts & trade war talks) ---> higher real (neutral) rate ---> a steeper path for short term interest rates ---> stronger dollar ---> muted US & global equity performance   

  

**Will tax cuts favoring the wealthy cause an increase in economic growth? (See the entirety of section three titled Monetary Offset):

Ironically, the Republican mantra especially since 2008 has been that fiscal deficits, a looser Fed, and a depreciation in the dollar exchange value are to be avoided.  Yet this combination is precisely what is required for the Trump tax plan to have its biggest chance of success.

It wasn't too long ago that the Republican believed that:

• Large fiscal deficits were harmful and to be avoided.
• An accommodative Fed was a symptom of morally bankrupt monetary mismanagement.
• Strong USD was a positive. 

How times have changed!