We’re seeing much the same approach to monetary policy around the world. The Reserve Bank of New Zealand (RBNZ), which has been threatening to go “full Switzerland” and start intervening in the FX market along with negative rates, briefed reporters on their possible additional policy measures. They made it clear that they’re preparing to do more. “We have a least regrets approach to thinking how much stimulus to deliver,” RBNZ Chief Economist Yuong Ha said. “We’d rather do too much too soon than too little too late.”
We heard the same line Tuesday from Fed Chair Powell. “At this early stage, I would argue that the risks of policy intervention are still asymmetric. Too little support would lead to a weak recovery…By contrast, the risks of overdoing it seem, for now, to be smaller.”
That statement can help us to understand one of the key lines in the minutes from the September meeting of the Federal Open Market Committee (FOMC), the US central bank’s rate-setting policy board. The minutes said, “many participants noted that their economic outlook assumed additional fiscal support and that if future fiscal support was significantly smaller or arrived significantly later than they expected, the pace of the recovery could be slower than anticipated.”
The phrase “significantly later than expected” is important, as it indicates the Fed views stimulus now as qualitatively different than stimulus in three months, when former VP Joe Biden will (we assume) be president. “The pace of economic improvement has moderated since the outsize gains of May and June,” Powell noted. “…a prolonged slowing in the pace of improvement over time could trigger typical recessionary dynamics, as weakness feeds on weakness.” Weak demand triggers bankruptcies and job losses, which causes demand to weaken further in a downward spiral that’s hard to break. It’s much harder to resuscitate someone once they’re dead and it’s much harder to create jobs when companies have gone bust.
The Fed is on hold for now while the indicators continue to improve and it waits to see what (if anything) the government will come up with. But once the data start to show the recovery stalling, it’s likely to move fairly quickly to ease further if they see that the fiscal authorities are incapable of action. That could put further downward pressure on the dollar.
What might the Fed do? It’s pretty much ruled out negative interest rates, which aren’t appropriate for the US — $4.4tn in money market funds makes it impractical to impose negative rates. A more aggressive quantitative easing (QE) might be the first option. “I can imagine wanting to shift to longer-term Treasuries, as we did during the Great Recession, if we needed more accommodation,” said Cleveland Fed President Mester (V) Monday in an interview with Bloomberg News. That would be a “soft” version of “yield curve control,” a policy that Japan and Australia have implemented. At the least, the Fed should provide “further detailed guidance on the Committee’s intentions regarding these purchases,” according to Kansas City Fed President George ((NV) on Thursday.
Yield curve control helps support the economy in two ways: the portfolio balance effect and the interest rate effect. As Reserve Bank of Australia Deputy Gov. Debelle said on 22 September:
Bond purchases have a portfolio balance effect in addition to the interest rate effect. When a central bank buys government bonds, it is exchanging a shorter duration asset (cash) for longer duration one (the bond). This incentivizes investors to switch into other assets, including potentially foreign assets, to get that duration exposure. This lowers interest rates on other financial assets and also can contribute to a lower exchange rate. (emphasis added)
Currently, U.S. Treasuries are an attractive investment for foreign fund managers. After taking hedging costs into account, they yield significantly more than bonds in other major currencies (or looked at the other way, foreign bonds yield a lot less than a currency-hedged Treasury). Lowering the yield of Treasuries would reduce their attractiveness to foreign investors while increasing the attractiveness of foreign bonds for domestic US investors. Result? A lower dollar (in theory).
This is one reason why I think Trump’s move to stop negotiations on CARES Act 2.0 – negotiations that weren’t going anywhere, but let’s put that aside – is negative for the dollar. It makes further easing by the Fed more likely, which is negative for the dollar.
There’s another reason, too. By reducing more people to poverty, it makes VP Biden’s election more likely. That’s negative for the dollar, because it would engender a “risk-on” mood that would probably reduce “safe-haven” flows into the U.S.
Don’t believe me? Maybe you’ll believe the European Central Bank (ECB). This is what they had to say this week in the minutes from their latest meeting (emphasis added):
…model-based analysis identified two main drivers behind the recent shifts in exchange rates. The first and most important one was the substantial improvement in global risk sentiment, i.e. the reversal of previous safe-haven flows into the United States. The decisive policy actions taken by euro area governments to fight the crisis had likely contributed to the improvement in risk sentiment. A second driver was likely related to monetary policies implemented in the United States and the euro area, in part reflecting differences in conventional policy space before the pandemic.
The data certainly demonstrate the “first and most important one,” as the graph shows.
As for the latter, we can see that factor in play when we look at the difference between the “shadow rates” for the ECB and the Fed — the policy rates adjusted to take into account the effect of quantitative easing and other unconventional monetary policies. Adjusted for such measures, the gains in EUR/USD clearly follow the Fed’s recent easing, which narrowed the gap between the ECB and the Fed’s “shadow rates.”
I think we are still in the beginning of a multi-year downtrend for the dollar that is just getting under way. With Trump doing his best to sabotage the U.S. economy and the Fed therefore likely to ease further, it’s got much further to run, in my view.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.