Talking Dollars On A Snoozer Monday

Let’s talk about dollars.

As you might have observed, the broad dollar got quite a boost from Friday’s strong payrolls number:

That’s basically just rate hike expectations. It’s a kind of “ok Janet, how are you going to justify not hiking now?” bet.

Of course the irony is that that dollar strength can and has served as an excuse not to hike in the past. Think about last September for instance. We were seeing a bloodbath in emerging market currencies. China’s move to devalue the yuan didn’t help. Had the Fed hiked, the exodus from EM would have accelerated. It would have been a taper tantrum on steroids.

But at a certain point, the FOMC is going to have to come to terms with the currency conundrum. There’s just no way around it. Yes, policy divergence comes with FX consequences and when you print the world’s reserve currency, those consequences can be dramatic. We’ve seen flows into EM assets of late and further dollar strength could curtail those flows, yield hunt or no yield hunt.

The stronger dollar also has the potential to crimp corporate profits and, perhaps more importantly, could very well prompt China to start moving the yuan fix even lower which of course is a risk-off trigger.

This is why the Fed should have never started adding things to the reaction function. It should have been data dependency all the way. Now, they’ve put themselves in a position where they can’t do anything. It’s policy paralysis.

One firm that’s been insistent on the idea that the market isn’t pricing in the “right” number of Fed rate hikes is Goldman. They’ve got their story and by God, they’re sticking with it. Here’s the latest from the Robin Brooks squad:

“Our economists forecast a hiking cycle of 300 bps for the Fed, with a terminal rate of 3.4 percent by end-2019. This is certainly more than is priced in markets and the main reason we remain structural Dollar bulls. That said, recent months have seen building Fed-speak around the idea that – despite near zero policy rates – the degree of accommodation is “moderate,” because R-Star is near zero. Indeed, only Vice Chair Fischer has not characterized policy as such, while the rest of the Fed leadership has embraced this language, even as financial conditions have eased sharply since early this year.”

(Charts: Goldman)

Ok, so “R-star” is just the neutral short-term rate. Goldman has been on an R-star kick lately. Consider what they said last week:

Sunday night saw a remarkably dovish speech from NY Fed President Dudley, which discussed the idea that R-Star may be around zero, such that US monetary policy is only moderately accommodative, despite policy rates being near zero. More striking, at least in our eyes, was his language on the Dollar, where he essentially made the case that weaker fundamentals elsewhere require a dovish offset from the Fed, to prevent the Dollar from appreciating. This language comes very close to ‘Dollar targeting,’ which the speech was quick to deny, and is a substantial about-face for President Dudley, as Exhibit 1 shows.”

(Charts: Goldman)

So essentially, the Fed is signaling that a weaker dollar is simply a necessary condition for global financial stability which of course argues against a rate hike.

Once again, the shift in the reaction function has created a quandary. You simply can’t protect emerging markets, keep the Chinese yuan devaluation at bay, safeguard multinational profits, and claim to be data dependent all at the same time in the current environment. It just won’t work. Which is why Goldman may want to rethink their thesis.

If we learned anything from March, it’s that the Fed is going to err on the side of preserving global financial stability. The jobs numbers be damned.

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