Yellen Steams Ahead On Fed Rate Rise But Concerns Mount On Dollar Shock
Comment of the Day

November 18 2016

Commentary by David Fuller

Yellen Steams Ahead On Fed Rate Rise But Concerns Mount On Dollar Shock

Here is the opening and also a latter section of this informative article by Ambrose Evans-Pritchard for The Telegraph:

A defiant Janet Yellen has vowed to complete her full term as chairman of the US Federal Reserve and defend the institution's independence, swatting aside vitriolic attacks on her policies by Donald Trump during the campaign.

“I was confirmed by the Senate for a four-year term, which ends in January 2018, and it's fully my intention to serve out that term,” she told Congress.

Mr Trump lambasted the Fed before his election for supposedly debauching the money supply, and accused Mrs Yellen personally of holding down interest rates to help the Democrats.

His attacks broke a long-standing taboo over Fed sanctity and raised fears that Mr Trump might try to turn the central bank into a White House political instrument, as it came close to becoming under the Nixon administration.

The irony is that Mr Trump may now face the rate rises that he demanded, and perhaps more than he bargained for.

Mrs Yellen gave the clearest signal yet that the Fed will raise rates a quarter point to 0.75pc in December, warning that waiting too long could store up serious problems and leave the bank scrambling to catch up later. “It could end up having to tighten policy relatively abruptly,” she said.

The Fed boss showed little concern about the surging US dollar, insisting that the latest rebound in economic growth and rising inflationary pressures implied rate rises “relatively soon”.

Her choice of words is as close as the Fed ever comes to a pre-announcement. “The coast is clear for multiple rate hikes in 2017,” said Michael Darda from MKM Partners.

The hawkish comments instantly tightened financial conditions, pushing up yields on 10-year US Treasury bonds to 2.28pc and lifting three-month dollar Libor rates to the highest level since since mid-2009.

These are the two key benchmark rates for the international system, setting the price for trillions of dollars of financial contracts.

The tightening was transmitted through the interlocking global nexus, with the usual amplification in southern Europe and across emerging markets. The US dollar index (DXY) surged to a 14-year high of almost 101 and this is compounding the effects.

And:

The Fed has more or less been forced to raise rates since the markets are already driving up long-term borrowing costs sharply. To resist this pressure is almost futile, and would fuel criticism that the central bank is falling behind the curve.

Yet there are risks to tightening at a time when nominal GDP growth is not far above recessionary stall speed, and when the strong dollar is causing ructions worldwide. Mrs Yellen said “global growth should firm” but this is questionable, and may prove a hostage to fortune.

The Fed has misjudged the global landscape time and again over recent years. It was stunned by the "taper tantrum" in May 2013, compelled to beat a hasty retreat when yields spiked and emerging markets crashed. Officials have since adjusted their model to take account of global effects and the "blow-back" into the US economy.

Yet doubts persist over whether the Fed has fully adapted to an international system with open capital flows that is more dollarised than at any time in history, with $10 trillion of dollar debt lying outside US control.

The Bank for International Settlements says there are already signs of a global "dollar shortage" and warns that the more the currency rises the more it forces automatic deleveraging for banks in Europe and Asia, and the more it sets off financial stress through complex swap contracts.

Paul Mylchreest from ADM says Chinese companies and entities probably hold $2 trillion of "short dollar" positions once contracts through Hong Kong, Singapore and Japan are included. This could lead to trouble as the dollar rises and funding costs jump.

“In our opinion, the risks facing China’s financial system – and therefore its economy – are far higher than is currently realised due to dollar illiquidity,” he said.

David Fuller's view

The Fed was hoping that the Dollar Index would spend more time in its consolidation range below 100, before resuming its secular recovery.  That might have given other large countries more time to strengthen their economies, theoretically allowing monetary policies to be coordinated in programmes of overlapping increases.  After all, that is what frequently happened during other recoveries over the last 70 years.

It was always wishful thinking.  The USA, despite an economically disinterested White House and dysfunctional House of Congress, has advantages that no other large country can match in this era: 1) self-sufficiency in the production of crude oil and natural gas; 2) a widening lead in the hugely important and accelerating rate of technological innovation; 3) far more world-leading multinational corporate Autonomies. 

Had the global economy remained locked in the post-2008 financial crash ‘new normal’ environment of minimal GDP growth and disinflationary pressures, as analytical group-think projected, the US Dollar might have remained rangebound for a longer period.  

Earlier this year, conventional thinking regarding monetary policy attempts to revive GDP growth with near zero or negative rates, while fiscal spending remained on hold, was undergoing a welcome reassessment.  After all, banking was overregulated and unable to profit from lending at zero interest rates; corporations were less willing to invest with government fiscal spending on hold, and debt was rising to unprecedented levels for this era.

Consequently, fiscal spending was increasingly being advocated, not least for the UK economy following the Brexit referendum, despite generally high levels of government debt.  Then the ‘impossible’ happened with Donald Trump seizing the presidency by challenging establishment views and promising the most aggressive reflationary efforts in modern history.   

Pre-US election, Wall Street had some hedge shorts and was also programmed for further selling in the event of a Trump victory’, but a few hours later smart investors realised that Trump’s economic policies were massively stimulative.  Today, we have a short-term overbought condition on for US share indices and a number of other stock markets.  However, they would have to close beneath their early-November lows to confirm that selling pressure had regained the upper hand. 

Returning to the Dollar Index, also shown above over 5-years, we may now see a momentum move following the breakout above 100.  I doubt the US Treasury and Federal Reserve will attempt to reverse this initial move which could easily carry to 110.  That would weigh on gold and other precious metals, while also pressuring countries with Dollar liabilities and weak financial sectors.  Sometime next year I would not be surprised to see the Dollar Index break above its 2001-2002 highs near 120.  

Here is a PDF of AE-P’s article.   

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