Is the Federal Reserve leading markets back to normality?

The Federal Reserve is not the first central bank to propose ending its emergency monetary policy. The Bank of Canada has already stopped its bond-buying.  But the American institution is far more influential and will lead the parade of higher interest rates. What are the currency and market implications in the new and very different economic world? Join FXStreet senior analysts, Yohay Elam, Eren Sengezer, and Joseph Trevisani for a look at the shape of things to come.

 

Yohay Elam: The dollar has been going from strength to strength in response to strong US data. Seems to me like a sign of normality, no more risk-on/risk-off. Or am I putting my rosy glasses on?

Joseph Trevisani: Covid spikes are becoming passe... I don’t mean they are not a problem for the places involved... but they are not moving markets... So yes I would agree… endemic not an epidemic.

Eren Sengezer: I don't think people are worried about lockdowns but COVID is likely to continue to have an impact on the labor market.

Yohay Elam: Yes, vaccines are in high availability and treatments are also set to help avert pressures on health systems.

Joseph Trevisani: Yes but vaccines do not prevent spread… so even places with high or relatively high vaccination rates have new Covid spikes…

Yohay Elam: Yeah, it seems that booster shots are necessary. A mix of reaching new populations and boosters helped crush the Delta wave in Israel.

Joseph Trevisani: I think Covid may play a part in the labor shortage in the US...but more I think is the reordering of work at home.

Yohay Elam: Covid is playing a part in labor shortage and also in supply chains. People are still buying more products than services. The faster covid moves away, the faster these supply chain issues subside.

Eren Sengezer: Going back to your original question Yohay, I think we are entering a phase of strong US data translating into stronger dollar. That type of straightforward market reaction could be a sign of the Fed moving towards normalization

Joseph Trevisani: The supply issues will slowly subside...there is an interesting personnel question on the Fed...the old adage personnel are policy my apply...

Yohay Elam: Goods vs. services

Joseph Trevisani: It is the Powell Fed that is moving toward higher rates next year. Will he be reappointed in February?  The Biden administration may want a scapegoat for inflation that is exacting a high political cost.

Yohay Elam: I think Powell and Brainard are equally dovish. But maybe he'll sacrifice Powell to keep the left-wing happy, compensation for a climbdown on their more ambitious spending goals. For markets, I think there should be little difference

Joseph Trevisani: I am not so sure...but even if so… I doubt the difference is important...I ask because I think Powell has the trust of the market, I think his communication has been excellent...

Eren Sengezer: I agree. I'm not saying Brainard would necessarily be a bad choice but markets like consistency. Especially when it comes to the Fed's policy outlook. Still, it would probably take one press conference for Brainard to reassure markets that they will stick to the current forward guidance. 

Joseph Trevisani: Agreed were Biden to appoint here the reasons would be political.

Eren Sengezer: Yes, Democrats probably wouldn't mind seeing Brainard as Fed chair in case the policy was to stay the same.

Yohay Elam: I also like Powell´s communications, but I think Brainard will not make any gaffes. I think she'll make Fed pressers great snoozers once again. That is bad for us but good for markets. Bullard suggested accelerating the taper speed from $15 to $30 billion per month and/or raising rates before tapering ends. He's an extreme hawk. But, do you think there is a chance for any quicker tightening than the Fed's current path?

Joseph Trevisani: Though the dollar has had an excellent summer and fall, US Treasury rates are still below their first-quarter peak.

Yohay Elam: Markets pricing lower inflation down the road?

Eren Sengezer: I think so, dollar strength reflects the relative strength in the US economy in my opinion. Yields are struggling to rise because inflation may still end up being transitory. Having said that, 2% is still an achievable target for the benchmark 10-year in my opinion. Before inflation starts to move back down.

Joseph Trevisani: Before March 2020 the 10-year average was around 2.25%...

Yohay Elam: That's quite a long way to go. Does it mean the dollar still has lots of room to run higher?

Joseph Trevisani: It should but I have been made wary by the Treasury market behavior.  The economy is clearly strong enough for the Fed to run the taper on schedule, ending in June. Futures have three fed funds hikes next year. Yet Treasury yields are stationary.

Yohay Elam: Three rate hikes in 2022 means good prospects for the dollar to rise. But perhaps markets are overreacting? Bullard said that has two hikes penciled in, and if the Fed goes slower than markets, perhaps the dollar could fall.

Joseph Trevisani: Three hikes would only get the fed funds to 1%. Sooner or later the ECB, BOE BOC will move to higher rates, everyone except the BOJ, at that point their policy will be the new information, and the Fed will be old hat.

Yohay Elam: Yes, it will finally be a race to the top, or at least not a race to the bottom, more exciting times. For the dollar, I think it could lose ground against some currencies, where central banks move faster, especially those of commodity currencies, Especially if America's October inflation figure was the high watermark.

Eren Sengezer: Do you think the Reserve Bank of New Zealand will act next week? 

Joseph Trevisani: The dollar has moved higher even though Treasury rates have not.  For instance, on Oct 21 the 10-year yield was at 1.675%, the euro was 1.1625, back on June 3 the 10-year was at 1.625% and the euro was 1.2125.  Seems like a case for divorce.

Yohay Elam: Correlation breakdown.

Joseph Trevisani: I do not think so.  Covid is much in the news. Truly. Reminds me of the labor market correlation breakdown. Initial Claims are not far from their record lows from before the pandemic, yet employment, at least as reported by the standard statistics, is far from the same level. Yet in Canada jobs are fully recovered.

Yohay Elam: To answer Eren Sengezer's question, my answer is yes, the RBNZ will raise rates, and the BOC will follow. The Great Resignation. People had time to rethink their lives. And there was pent-up demand for retirement.

Joseph Trevisani: I disagree. I think the RBNZ will wait until the Fed's coast is clear. BOC also.

Yohay Elam: But it's only in the US, it's a global phenomenon.

Joseph Trevisani: I agree I think the lockdowns have had a social and cultural effect wholly unexpected.

Eren Sengezer: I don't think anyone is expecting employment to return to pre-pandemic levels.

Yohay Elam: There are work shortages even here in Spain, where unemployment is double-digits. There aren't enough nurses and construction workers are also in high demand. I guess other sectors are struggling to find workers.

Joseph Trevisani: It does appear to be a social, not a market development.

Eren Sengezer: Precisely, that's why Fed looks for "good enough" jobs figures rather than hoping to return to pre-pandemic levels.

Joseph Trevisani: Which is a change from their original rhetoric.

Yohay Elam: Yeah, the Fed cannot solve social developments, nor supply-chain issues. Maybe that's a cause to stick to the current path.

Eren Sengezer: They have to recognize the structural changes in the economy due to the pandemic and adjust their policy/forward guidance accordingly. Or the Fed might end up causing asset bubbles.

Joseph Trevisani: One could argue they already have caused asset bubbles.

Eren Sengezer: That just might be so... The severity of the correction is likely to reveal the size of the bubble. In case the reflation trade turns into stagflation trade. 

Yohay Elam: A bubble is a bubble only when it bursts.

Joseph Trevisani: Very true. Much the same was said during QE after the financial crisis...but there was no sustained fall until COVID.