In this briefing:
- Insurance Rate Cut Will Not Reduce Political Pressure on the Fed Nor Weaken the Dollar
- Rates Monitor: Zero in on US Rates
- Great Currency War: Slowing Global Economy Will Test Truce
- Big Issues Holding Down AUD/NZD Have Flipped
Hitherto, the Fed’s dovish policy tilt has not produced significant dollar weakness, an outcome beneficial for foreign investors in US equities. Meanwhile, previous economic cycles cannot provide definitive clues about the direction of the exchange rate at this stage of the current expansion.
Given the likelihood of policy easing by the European Central Bank and Bank of Japan, US monetary conditions will need to ease by a higher order of magnitude to produce meaningful dollar weakness. If the Fed’s actions fail to weaken the US currency then the Trump Administration could actively seek to talk down the dollar, despite current assurances to the contrary.
Although headline Q2 real GDP data confirms an ongoing slowdown, aggregate final private demand remains robust, thereby lowering the chances of aggressive Fed policy easing.
Normally, an insurance rate cut by the Fed would lower borrowing costs and ease financial conditions, but the Fed’s dovish tilt has already achieved these conditions. Fed Chair Powell will argue that a policy rate reduction is required to reverse earlier damage to US business sentiment.
The prospect of continued pressure on the Fed from the Trump Administration will keep the issue of policy independence on the radar screen. A recently passed measure to temporarily suspend the federal government debt ceiling until 2021 is a forerunner to another round of fiscal easing, an outcome that raises pressure on the Fed to provide an appropriate offset.
We are launching our Rates Monitor to track movements in global interest rates.
- The US Federal Reserve Bank could be entering policy accommodation at its upcoming meeting on July 31, in our view. We note that historically, episodes of policy accommodation have lasted for a considerable number of months. Furthermore, the number of rate cuts (or QE equivalent) needed have been significant.
- If the historical trend is repeated, policy rates could eventually hit zero and it is potentially likely for the Fed to look for measures beyond rate cuts.
- However, long-term rates today are also not significantly above the zero-lower bound. The closer they approach the zero limit; somewhat lesser the ability of unconventional policy measures to stimulate.
Concerns about the slowing global economy will raise the importance of currency movements in 2019 H2 as a means to mitigate headwinds to growth. In particular, the Trump Administration seems keen to preside over a weaker dollar, particularly versus the euro and the yuan.
Markets are discounting policy easing by the Fed and the European Central Bank (ECB) that could push the yen higher in the event of no response by the Bank of Japan (BoJ). The sales tax increase in October raises downside economic risks in Japan that could ultimately force more policy easing by the BoJ.
The yuan briefly appreciated in the wake of news about the US and China resuming trade negotiations, but a final agreement is unlikely any time soon. Further monetary stimulus is likely to arrive via lower reserve requirements for banks, while deliberate weakening of the currency by the People’s Bank of China will only be contemplated if US-Sino trade talks collapse.
The current environment differs from the post-Plaza Accord environment due the persistence of low inflation and strong US growth relative to the rest of the world that has attracted strong capital inflows. A weaker dollar will require a degradation in the post-tax returns on US assets via significantly slower growth or degraded corporate operating performance.
Historically, the Fed has never targeted the US exchange rate as a policy objective, although it monitors the currency’s impact on inflationary expectations and financial conditions. Continued repetition of June’s strong Employment Situation report will make justifying three reductions in the federal funds rate in H2 impossible, thereby reducing the prospects for a weaker dollar.
AUD/NZD is still languishing around record lows. Pessimism over the AUD increased as the Australian economy stalled in the second half of last year, the Royal Commission into the financial sector unsettled confidence, the housing market downturn accelerated, political uncertainty peaked into the national election in May, and the RBA scurried to cut rates twice at back-to-back monthly meetings in June and July. Now the regulatory, political and economic trends are moving in favour of the AUD and against NZD. RBNZ is toughing capital requirements on NZ banks. The Australian housing market is stabilising, NZ’s is slowing. The Australian political cycle is as positive as it has been for a decade, and tax cuts have been delivered. Australian trade performance is much stronger, and its fiscal position has caught up to and over-taken NZ’s. NZ is expected to cut rates in August and is largely pacing Australian rates lower.