So much depends on the Federal Reserve. Yes, it’s still true, even after eight years of extraordinary central bank action to support the economy.
For some time, we’ve been observing that the supreme variable for investors to track and study is the strength of the U.S. dollar. The dollar’s strength, in turn, is profoundly influenced by central bank policies: not just that of the U.S. Federal Reserve, but those of the world’s other major central banks, including the European Central Bank (ECB), the Bank of Japan (BOJ), and the People’s Bank of China (PBOC).
None of those influential central banks operates in a vacuum, of course. Both overtly and through back channels, they coordinate policy with one another at least in broad strokes. This is why, despite many fears, we have not seen a race-to-the-bottom, beggar-thy-neighbor currency environment, in spite of the increasing volatility in currency markets and in spite of apparent “surprise moves” (the kind of moves for which the BOJ has acquired a reputation). Competitive devaluation would see the major central banks racing to weaken their currencies to secure trade advantages -- and that, so far, has not been widespread.
There have been significant movements, but they have not caused financial disorder or dislocation, in spite of the negative effect (for example) that the appreciation of the U.S. dollar has had on the earnings of U.S. multinationals. The effects have so far been controlled.
The figure below shows three currency indices -- tracking the U.S. dollar, the Japanese yen, and the euro, respectively -- each against a weighted basket of their trading partners’ currencies; the lower panel shows the S&P 500 index. We are presenting this chart to show that U.S. stocks have not been severely damaged by currency fluctuations in the past few years (except perhaps that the rising dollar has contributed to the decelerating post-crisis appreciation of the S&P since its high last May).
Source: Bloomberg
What’s Going On With the Fed?
As readers know, the U.S. Federal Reserve has a dual mandate -- to optimize employment and price stability. Both of these variables are at or near optimal levels. U.S. unemployment has been near the 5% rate that’s considered “full employment” for three quarters of a year. May’s unadjusted headline consumer price index (CPI) excluding food and energy costs was up 2.1% over the past 12 months. Many indicators suggest that accelerating inflation is coming into view (more on this below).
Such huge economic aggregates are powerful -- when they are on the move, the backward-looking data collected by the Bureau of Labor Statistics are almost certainly a sign that acting now is already late (indeed, it has probably been late for some time). Yet the Fed has been less than resolute in taking action.
Inflation
While Fed chair Janet Yellen may be looking to the third decimal place on the unemployment readout that’s front and center in her policy-determining dashboard, she doesn’t seem so concerned to probe deeper into the inflation readout.
Yet that inflation readout is highly questionable. Although we don’t know how quickly energy prices will rebound in coming months, they will be lapping 2015's large decline. Excluding food and energy during the decline may have resulted in an overstatement of inflationary pressures; now excluding them will make it more likely that real inflation being experienced by American consumers is being understated.
The four largest components of spending for most American families are rent, food, energy, and medical care, and all four of these have been advancing faster than headline CPI for more than 20 years. Overall, they comprise about 60% of the average consumer’s spending basket, but for working-class families that rises to 80%, and for poor families, as much as 90%. Since 1995, the average year-over-year inflation rate for energy has been 3.9%; for food, 2.6%; for shelter, 2.7%; and for medical care, 3.6%. Yet CPI has averaged only 2.2%.
This explains the divergence between the experience of American families and the readout on Ms Yellen’s dashboard. To take an extreme example, in the five years leading up to December 2015, the price of beef was up 80%, and the CPI up a cumulative 7%. This is in the context of near-stagnant real per capita GDP growth and stagnant median income levels. No wonder Americans are ready to cast their ballots for anti-establishment candidates.
We believe that developing economic conditions will only cause this divergence to accelerate as inflation gains steam.
What is really going on? Certainly, the economists at the Fed are well aware of what we’re writing. This makes it even more inexplicable that they seem to be asleep at the switch and delaying because they are slow-moving. Something else is happening -- what is it?
Critical Factors Responsible for the Fed Delay
Their decision rests upon other variables than just U.S. economic data. Whether the public understands it or not, the Fed is also responsible for the smooth operation of the world’s banking and trade systems. The value of the Chinese yuan versus the U.S. dollar has become a significant measure of stability in the world, and is affecting market psychology.
We believe the Fed’s deepest concern in the short term may be neither U.S. unemployment or inflation, nor the policies of the ECB and the BOJ. Rather, the currency stability management of the People’s Bank of China may be the thing the Fed wants to support.
Former Minneapolis Fed Chair President Narayana Kocherlakota wrote the following on March 14:
“The world’s largest currency union contains about 1.7 billion people and accounts for more than a third of global economic output… I’m talking, of course, about the U.S. and China. For more than 20 years, China has kept the yuan’s value against the dollar in a very tight range… Financial markets have come to expect little short-term volatility, and were unpleasantly surprised when the yuan dropped 1.9 percent in one day against the dollar last August.
“This connection between the yuan and the dollar has important implications for the impact of U.S. monetary policy on China. Changes in the U.S. Federal Reserve’s interest-rate target affect the U.S. economy in part by causing the dollar to appreciate against other currencies, such as the euro and the yen. If China holds its exchange rate to the dollar stable, the Fed’s moves will also cause the yuan to appreciate against those other currencies, putting downward pressure on Chinese inflation and employment at a time when this might not be appropriate for the Chinese economy…
“It has always been clear, though, that China would no longer want to use fiscal policy in this way once its economy was sufficiently developed. The country's currency moves over the past few months suggest that it might have reached this point. In other words, the time may have come for China to break away from its currency union with the U.S… There's a significant risk that if the Fed keeps tightening in 2016, it could force an abrupt breakup. The resultant disorder in the world economy would not serve Americans well.”
Jefferies analyst David Zervos has developed Kocherlakota’s logic. At this point, he believes, facing slowing growth and the challenges of ultimately unwinding a large financial bubble, the Chinese do not want the yuan to appreciate. Fed tightening would lead to dollar appreciation, and bring the yuan along for the ride… as long as the link is intact.
What would breaking that link look like? Kocherlakota says that “an abrupt breakup” would cause “disorder in the world economy.” Certainly a disorderly event of this kind would be disruptive; it would be especially disruptive, though, to financial markets. Our graph above did not show the U.S. S&P 500 index suffering notably from the long post-crisis currency moves. Last year and this year, though, presented a different picture when it comes to the yuan:
Source: Bloomberg
In both August and December/January, rapid yuan depreciation corresponded with sharp corrections in the S&P 500.
The Fed Is Facing a Major Quandary
Do we think that these corrections presage disaster? Not at all. When the yuan-dollar “peg” is finally broken -- which is probably inevitable some day in the future if China’s development continues -- there will be disruption, but most likely not catastrophe. However, if last year’s market jitters surrounding the yuan are a sample of the probably worse effects that would ensue if the peg were broken, we are pretty sure that the Fed’s Open Market Committee does not want that level of market disruption at the moment. Can they maintain this apprehensive stance in the face of good unemployment numbers and increasing inflation pressure?
This is the vice that the Fed finds itself in: squeezed between fundamentals that are shouting for a rate rise, and worrisome consequences of further instability in the quasi-fixed relationship between the dollar and the yuan.
We believe that the recent rally in U.S. equities is being driven by the following perception: although many Fed figures have been telegraphing that rate hikes are very much on the table, the yuan has not reacted strongly -- an indication that the PBOC understands Ms. Yellen’s need to proceed with slow normalization, and is willing to cooperate.
Political Reasoning
There are other considerations adding to the pressure on the Fed.
In June, we’ll have the U.K.’s vote on European Union membership, which currently is skewing towards a vote to stay -- but with a large part of the electorate saying they’re undecided, a “leave” vote is still in play. The outcome presents its own host of uncertainties into which the Fed may hesitate to inject more anxiety. The Brexit vote will certainly be on the minds of FOMC members as they consider raising rates in June. We note that although the polls show a tight vote, British book-makers are painting a different picture, with an 80% likelihood that the UK votes to stay.
What about later in the year? After its June meeting, the FOMC will meet again in July, September, and November.
It is also no secret that the political leanings of many FOMC members are in the direction of moderate, mainstream Democratic opinion -- and global financial uncertainty, stock market volatility, and potential economic anxiety would likely be seen as positives for a Republican challenger, particularly an anti-establishment figure such as Donald Trump. As Mr. Zervos says, Ms. Yellen has seen two examples of the market’s reaction to dollar-yuan instability -- and she likely does not want a “three-peat” in an election year.
On the other hand, many FOMC members have been broadcasting their desire for a raise far and wide, without counterbalancing words from the doves. Certainly, the domestic economic data warrant Fed tightening, and they have for some time. A purely data-driven Fed would perhaps act more rapidly. However, the Fed is not at present purely data-driven; or at least, the data being watched are broader than what is expressed explicitly in the Fed’s mandate. The global need for stability and order in the dollar-yuan relationship, as well as related domestic political considerations, may well be the subtext of the Fed’s policy path in 2016.
What remains to be seen is how the oil and water will mix: on the one hand, economic data which make the case for higher rates ever clearer; and on the other hand, a domestic political and global financial backdrop which are applying pressure for the FOMC to rein itself in at least until after the November U.S. elections.
The fate of those assets which benefit from a sideways-to-weaker dollar -- gold, oil, other commodities, and the beaten-down currencies (and possibly stocks) of commodity-producing countries -- will depend on the path the Fed takes.
Investment implications: Dollar strength remains the key variable for ourselves and investors to watch -- and at this juncture, the Fed will have the greatest influence on the dollar. The Fed finds itself in a quandary. On one hand, unemployment and inflation are both at levels that suggest normalization is more than warranted -- indeed, these backward-looking data likely show that the Fed is well behind the curve. However, the Fed is also deeply aware of the significance of the Chinese yuan’s historical fixed relationship to the dollar -- and aware that if the yuan is dragged up by a rising dollar, the Chinese may feel the need to intervene and weaken (or even break) that fixed relationship. In the past 12 months, the two occasions of yuan-dollar volatility corresponded with sharp corrections in the U.S. S&P 500 index. Will the Fed risk such instability again, on the eve of the Brexit vote, or as the U.S. Presidential election draws closer? Investment strategy hinges on this question. We argue that the summer of 2016 may prove to be bullish for stocks, because Brexit will not become a reality.