Tuesday, December 1, 2015

Interest rate spreads drive the dollar

With U.S. short-term rates rising and Eurozone rates falling deep into negative territory it's not surprising that the dollar has been gaining against the Euro. Behind these moves is a U.S. economy that appears healthier than the Eurozone economy, and that in turn conditions markets to expect very different monetary policy conditions for the foreseeable future. The dollar's strength to date is salutary and not overdone, so it doesn't present a problem for the U.S. economy. (Question to those who worry about the strong dollar: If a stronger economy is what is driving a stronger dollar, why should a stronger dollar be bad for the economy?)

The chart above compares 2-yr Treasury yields with 2-yr German yields. They have diverging for almost two years now, driven by the growing perception that the Fed would raise rates sooner than the ECB, and more recently, by the ECB's professed willingness to actively pursue easier monetary policy for the foreseeable future.

The chart above makes it clear that interest rate differentials between the U.S. and the Eurozone (blue line) go hand in hand with changes in the Euro/dollar exchange rate (red line). The dollar has strengthened vis a vis the Euro in line with more attractive U.S. interest rates.

The chart above compares the dollar value of the Euro against my calculation of the dollar's Purchasing Power Parity against the Euro (green line), which can be thought of as the exchange rate that would result in prices in the Eurozone being generally comparable to prices in the U.S. By my calculations, the dollar is almost 10% above its PPP value against the Euro, which means that U.S. tourists to the Eurozone should find that things are a bit cheaper there. It's nice to have a strong dollar, and it's not strong enough at current levels to worry about.


Benjamin Cole said...

I stole this comment from Kevin Erdmann: the Fed will be able to raise rates the way a kangaroo can fly.

Time will tell.

John Cochrane says raising rates will raise inflationary expectations, setting off an ugly feedback loop, possibly.

As of now, the Fed could be said to be operating a contractionary policy. Think about it: the Fed is paying banks NOT to lend (IOER) and is drawing money out of circulation (selling bonds, shrinking Fed's balance sheet). The Fed can diddle with short-term rates, but that is a sideshow.

It could be said the Fed is running a very tight monetary policy while both economic growth and inflation are below target.

A great way to encourage socialism is to suffocate capitalism.

Matthew Grech said...

Benjamin: Add to your body of evidence that the Fed is running a contractionary/deflationary policy the price action of gold and of commodities more generally. The gold chart if telling us that the Fed is too tight. The action is not reflective of something transitory - this is now a long term trend and the Fed seems blind to it. Scott and others will come back with long term charts showing that gold is not "too low." Rather, it is within the band of normal. But I think this line of reasoning is off. The antidote to monetary instability is monetary stability. A flat gold price would be evidence of monetary stability (especially if it were confirmed by other metrics, like TIPS spreads and the like). It doesn't matter where gold has been over twenty years. A stable price, combined with the expectation of future stable prices, should be the goal. The Fed has demonstrably failed at that.

I would shut my trap about gold if gold were an outlier. But as you and many others have pointed out, there are other compelling signs that confirm what gold is saying.

The economy can withstand a quarter point hike. But that shouldn't even be in the conversation. The Fed should come out and say something like: We are targeting 10-year TIPS spreads of 2% (1.6% now), or we are targeting a PCE deflator of 2% (1.3-1.4% now) or, heaven forfend, we are targeting a flat gold price. They could even say that they're targeting a broad basket of commodities and seek to make that basket stable in price. The key is to target a longer-term, market-verified price. If they did that, and the market believed them, we'd see a meaningful improvement in the economy as well as a 25% (at least) boost to the stock market (due to increased certainty and, dare I say, a boosted sense of economic fairness). But I'm not holding my breath.

Short of making a big bold call, the Fed could make a worthy strategic call (which would boost certainty) by simply saying that the market shouldn't worry about inflation so much. Not only is every meaningful stat (TIPs, gold, PCE, commodities) saying that we're well short of our 2% goal, BUT WE HAVE A HAMMER LOCK ON INFLATION THROUGH THE IOER. This is a new aspect of controlling inflation that we haven't had in the past.

I fully understand why the beneficiaries of a fiat currency won't even talk about gold. I hate it but I understand it. But why won't they let IOER even enter into the conversation? It's puzzling.

Benjamin Cole said...

Matt: I agree with much of what you say. For 35 years we have heard that money is loose in America, and now we are on the cusp of deflation.