The question is not what the Fed will do, but what the ECB will

Outlook: This is a soft week for data, giving everyone time to second-guess the Fed the following week (June 15). Of great interest is the Reserve Bank of Australia meeting overnight tonight, with nary a soul having a faintest about whether the inevitable hike is 25 p, or 40 bp (to take it to 0.75%). Some say 50 bp. In addition, comments from the Gov can be confusing, or at least obfuscating. Inflation is running at around 2.1% q/q but various measures have it as high as 5.2%, so whatever else it may be, the real rate is badly negative. In addition, Australia has the highest home price inflation of any of the majors. The RBA “should” be as hawkish as it’s possible to get. For some reason, though, the RBA tends to be a bit wussy (sorry, mates).

Not noted on the Econoday calendar is the Atlanta Fed GDPNow to be updated tomorrow. Last week it got cut to 1.3% from 1.9% on several factors but prominently personal spending down from 4.7% to 4.4% and real gross private domestic investment growth more negative from -6.4% to -8.2%. We need to be careful not to attribute too much meaning to private investment, and for some reason it’s escaping the recession gloomsters, but to some extent it does represent both sentiment and future growth.

It was a little funny how fast payrolls departed the scene after coming in better then forecast and better than the ADP. As we wrote then, expectations of policy implications were silly. You simply do not get a shift in policy from a single data-point in a series that has already been relegated to the back burner. To the degree it retained any meaning, payrolls cemented the idea of Fed resolve for at least two more hikes of 50 bp each.

Similarly, politically motivated scorn for the Biden government to try to rein in inflation is misplaced. Governments are damned if they do and damned if they don’t. Government did not cause inflation and government can’t fix it, and let’s cut it out with the hypocrisy that wants government out of business but then weeps when government is not interfering more. Not least because interfering almost always backfires because if cack-handed administration.

Going into that next Fed hike and first round of QT, it was astonishing to see the Bloomberg MLIV Pulse survey coming up with no recession this year (but maybe next). Sectors that need high liquidity the most are going to do the worst, duh. Analysts wonder just how much extra leverage traders did add on, after all. As Buffet puts it, we are about to find out who has been swimming naked.

Not to be argumentative, but the WSJ has recently discovered the dollar and is delivering verdicts as though it has some knowledge and insights. It has neither. For example, “A run of mixed economic data is dragging on the U.S. dollar, stalling a rally that has rippled through the economy and financial markets. The WSJ Dollar Index, which measures the dollar against a basket of 16 currencies, is around 2% off its May peak and fell 1.1% last month. That decline broke a steady march that brought the dollar to multidecade highs. The index rose 0.6% last week, breaking a two-week losing streak.

“Behind the slip has been a subtle shift in the economic landscape. According to recent economic reports, American consumers are still spending money at a rapid pace, while employers keep adding jobs, extending the trends that had helped lift the dollar over the past 12 months or so.

“Yet there have been signs of weakness elsewhere. Wage growth has moderated from last year, and consumers have been able to sustain their spending only by dipping into savings. The U.S. service sector, which includes restaurant dining and travel, slowed its pace of expansion in May, and sales of new homes in April posted their biggest drop in nine years.

“Overall, the data has clouded some asset managers’ outlook of the U.S. economy. They are now wary that the Federal Reserve might have to slow the pace of expected interest-rate increases. That might be welcomed by stock investors, who are acutely aware of the risks that rising rates pose for highly valued shares, but its meaning would be murkier in currency markets.”

To pause here: a dip in services is so far a one-time thing, not a trend, a slowdown in wage growth is barely noticeable and only biased folks think anything in the labor market short of a massive change would stay the Fed’s hand.

To resume: “Investors typically buy currencies linked to countries where central banks are raising interest rates to rein in a hot economy. Investors expect the Fed to lift rates by a total of a percentage point in June and July, but what will follow is harder to determine. As a result, traders now contend that the dollar is more sensitive than usual to economic releases on the horizon.”

Well, no. The ruling principle is the relative real return, or rather the expected relative real return. The question is not what the Fed will do, but what the ECB will do as the Bund return is climbing steadily, even though there is far more uncertainty about the policy path there. The only mystery is why the yen gets firmer on no yield change or news at all.

The WSJ calls it a “muddied outlook [that] represents a shift in markets, after investors bet that a rapid pace of rate increases would drive the dollar higher throughout the year…. In the UK, sterling fell when the BoE spoke out against hikes as counter-productive and “Investors are now watching U.S. data for signs of similar slowing.” Ah, but the US doesn’t have Brexit, remember?

Just about the only true and useful thing in the dollar story is uncertainty about that happens in September after those two rounds of 50 bp. Looking at mortgage rates? The final joke is the Fed perhaps drawing in it horns at mortgage rates killing off the housing market. No, not even remotely plausible., We believe in free markets, remember? The Fed has no mandate to keep housing affordable, and mortgage rates of 5-7% are not un-affordable.

You can’t throw a handful of factors that some economists and some equity traders care about, mix it up, and turn on the heat, and expect to get beef Wellington.

If traders are reducing long dollar positions, and they are, it’s not because they expect the Fed will chicken out. It’s because traders perceive risk as falling or getting reduced by current events, making other currencies more interesting. Risk aversion favors the dollar as the safe haven and when the need for a safe haven weakens, so does the dollar. As for the Fed chickening out, the current thinking is one 50 bp hike in June, one 50 bp hike in July, and at least 25 bp in September, not two 50’s and then nothing. Any hesitation is more likely due to the possibility of what Bloomberg calls “peak inflation.” Some economists think the worst is over and early birds can bet on an end to hiking by year-end.

This is a solid maybe. The problem, as we complain about a lot lately, is the lag in real data that is a response to real or expected rate conditions. To be fair, we think we know the lag in various variables but in practice, lag is a range, not a single fixed number of months. The Fed economists are as good as any and better than most, but even if they were to concur peak inflation has been reached by the September FOMC, the Fed may prefer to overshoot to the upside for credibility reasons.

Then starts the slow process of delivering the peak inflation message so as not to appear ahead of the curve or behind it. We feel Sept is too early for data to feel securely valid even if the Fed’s economists do see the peak, so the Fed can stop sounding so hawkish in Oct-Nov–just ahead of that recession. Bottom line–no recession. It’s an entirely plausible scenario. It’s also dollar-negative, even as he Fed will be delivering the least negative real rates around. This is the essential perverseness of the FX market. We have seen it all too many times before, too. This is the sense in which a “weak” dollar is a good thing.

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

To get a two-week trial of the full reports plus traders advice for only $3.95. Click here!