Declining USD sowing the seeds of its own revival
- A weakening USD is good news for the Fed, as it will help boost inflation
- An update of the Fed's preferred inflation data is due out next week
- AUD and NZD benefit from USD weakness, despite dormant inflation downunder
A falling USD might have been expected to give the Federal Open Market Committee increased confidence that its 2% inflation objective could be achieved sooner rather than later, but there was no evidence of that in the monetary policy statement released on Wednesday. Instead, members expect inflation to remain “somewhat below” 2% in the near term. They will be “monitoring inflation developments closely”, a subtle hint of concern perhaps that “somewhat” below 2% could develop into “significantly” below.
An update on the Committee’s preferred inflation measure, the price index of personal consumption expenditures (PCE) is due next Tuesday.
The FOMC’s lack of confidence gave FX and fixed income traders cause to pull USD and bond yields down. The line in the statement saying the Committee expects to begin implementing its balance sheet normalization program “relatively soon” had little impact.
Three rounds of QE have seen the Fed’s balance sheet rise to $4.5 trillion and the plan is to cut it in half over a two to three year period.
Know when to hold ‘em; know when to fold ‘em
One would expect talk of a withdrawal of buying support for the US bond market would be putting upward pressure on yields but, so far at least, that’s not the case, probably because the Fed’s balance sheet size is matched by that of the Bank of Japan and European Central Bank (with the Bank of England contributing a bit on top).
In a global market place, relativities matter, and US yields won’t rise in isolation. The Fed might be looking at folding, but the others are holding.
Central bank balance sheets
Source: Financial Times
AUD and NZD have become the main beneficiaries of USD weakness, despite the fact that inflation is dormant down under as well. The June quarter inflation update out of Australia showed the headline rate at just 1.9%, back under the 2%-3% target band, while the core number held steady at 1.8%.
That doesn’t seem to be any cause for concern at the Reserve Bank of Australia. In a speech on Wednesday, RBA governor Philip Lowe commented: "We have not sought to stimulate a rapid lift in inflation. The fact that the labour market has been generating sufficient jobs to keep the unemployment rate broadly steady has allowed us to be patient."
Lowe said that "our judgement has been that seeking a more rapid pick-up in inflation through yet further monetary stimulus was likely to add to the medium-term risks. Our central scenario remains for underlying inflation to pick up gradually as the economy strengthens."
Australia's inflation trend
Those RBA comments sound like a recipe for an unchanged policy rate (1.5%) for the remainder of this year and probably 2018 as well. This could put downward pressure on AUDUSD as the interest rate differential will move in favour of the USD for the first time in two decades, assuming the Fed sticks to its guns and hikes once more before year end and three times in 2018.
A similar situation applies in New Zealand where the central’s banks preferred measure of core inflation is holding steady around 1.5% and showing no signs of budging. Noise around the headline rate caused by energy and food price fluctuations might get the markets excited from time to time, but in all likelihood the policy rate in New Zealand (1.75%) will be held steady through 2018 as well.
New Zealand inflation
Source: Reserve Bank of New Zealand
The Swiss National Bank is not showing any signs of changing its policy rate either. A setting of – 0.75% on its own is not deterring foreign capital inflow or encouraging Swiss capital outflow leaving the exchange rate “significantly overvalued” according to the bank’s assessment and requiring persistent intervention in the FX markets to hold it down.
Unlike other central banks conducting QE, the Swiss are not active in the local bond market and medium to long term yields are set by market forces. Recently, after a long period in negative territory, the return on the 10-year confederation bond has put its head back up above zero
Swiss 10 year government bond yield
Source: Wall Street Journal
A weakening USD will be good news for the Federal Reserve as it will increase input prices and give a modest boost to inflation. Other central banks will be worried out negative fallout in their own jurisdictions as export receipts in local currency terms decline, acting as a drag on national incomes, and lower input prices further delay a return to inflation targets.
Interest rate hikes will be off the agenda again, leaving the stage to the Fed. The net result might be that this period of USD weakness is sowing the seeds of its own revival.
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– Edited by Robert Ryan
Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.