Dollar Dilemma Looms As Greenback Hits Three-Week High

“We’re in a world where they seem to work. They may be difficult to deal with for savers, they go along with quite decent equity prices.”

That rather disquieting quote is from Fed Vice-Chair Stanley Fischer who was the Fed speaker du jour on Tuesday in yet another week where markets are simply waiting around on one catalyst (Friday’s NFP print). Fischer’s closely-watched comments on Bloomberg TV weren’t really anything new and as far as we’re concerned go further towards validating the contention that the “data” central banks care most about are asset prices and relative FX levels.

On rate hikes Fisher remarked that “the work of the central bank is never done, and I don’t think you can say ‘one and done’ and that’s it.” “We can choose the pace, but we choose the pace on the basis of data that’s coming in,” he added.

Yeah, yeah. That’s true - but only when it comes to negative data. As we’ve said before, there’s always an excuse not to hike (he made sure to mention lackluster productivity growth). Especially when you’ve explicitly added international financial conditions into the reaction function. You can’t ever forget how much of an impact the dollar has on emerging markets and commodities - especially now that the Chinese devaluation is in play. Why do you think stocks and oil prices did so well following the so-called “Shanghai Accord” in February and the Fed’s subsequent dovish lean in March? Here’s a hint:

So what you’re seeing there is that off the February lows, you’ve got a flat dollar (pink), a stable USDCNY (red), European stocks (light blue) up nearly double-digits, US stocks (dark blue) up even more, and crude (orange) soaring. Meanwhile, have a look at EM flows:

(Charts: Barclays)

And here’s a look at EM FX flows:

As Barclays puts it, “we think the outlook for core rates is among the most pertinent risks for EM assets at this stage. Hence, any moderation in flows likely reflects some investor hesitation ahead of the Jackson Hole meetings.”

Right. In other words, you start hiking rates and you jeopardize EM same story as last year at this time only now EM is playing from a position of relative strength. Here’s a bit of additional color from SocGen:

“That the flow of money into higher-yielding assets has been bad for the dollar isn’t surprising. The Fed has aided and abetted the move with its reluctance to tighten policy. And it’s easy enough to justify the Dollar under-performing the Yen and the Euro given that the Eurozone and Japan enjoy (or are cursed with) huge stocks of excess savings, visible in their current account surpluses and in Japan’s case, in the overall net international asset position. So whereas the global hunt for yield is a drag on the dollar despite the US economy’s relative strength and the higher real (and nominal) yields on US assets, the yen and Euro have both outperformed the dollar so far this year - by 20% and 4% respectively.”

“The FOMC is obsessed with making sure that rate hikes don’t cause collateral damage by coming as a surprise and the memory of the ‘taper tantrum’ three years ago is still raw enough. Absent a surprisingly sharp pick-up in inflation, when the Fed does finally hike, the FOMC will then go back into its shell to see what happens.”

(Chart: SocGen)

You also risk putting pressure on China to weaken yuan fixings which, as we’ve seen, can trigger global turmoil. True, the PBoC has had a helluva run recently when it comes to adopting a strategy of dollar stability but yuan weakening versus the trade-weighted basket, but again, that’s due largely to the stable dollar.

And then there’s the whole “a stronger dollar will dent already fragile US growth” argument which Fischer pretty much summarily dismissed on Tuesday.

So you can see how complex this has become in the increasingly interconnected global economy. The broad dollar is already at a three week high:

If we get anything above 180K on Friday then, well, see all of the above.

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