Jay Powell and the Fed face ‘dollar doom loop’ dilema

Why the US central bank is damned either way as it faces choice on September rate rise

Joachim Fels


Damned if they keep raising, damned if they don’t. Federal Reserve chair Jay Powell and his colleagues face a difficult choice over the next few months — and it is one that could have unpleasant ramifications whatever they decide.

The first option for the Fed’s Open Market Committee is that it continues to deliver on the current plan: raise rates again next month and stick to the guidance of four additional rate increases by the end of 2019. This can be easily justified by the US economy’s progress towards the central bank’s dual objectives of full employment and 2 per cent inflation as Mr Powell emphasised again in Jackson Hole.

However, the Fed is not only the US central bank but also the pacemaker for the global credit cycle. Courtesy of ultra-low US interest rates, quantitative easing and a relatively weak dollar following the global financial crisis, borrowers within the US and, even more so beyond, have piled into dollar-denominated debt. According to BIS data, dollar credit to non-bank borrowers outside the US doubled to $11.5tn since the financial crisis. Within this, dollar debt in emerging markets surged from about $1.5tn 10 years ago to $3.7tn this March.

As the Fed absorbs excess liquidity by shrinking its balance sheet — and the US currency and rates rise — this dollar debt binge has come back to haunt borrowers. The weakest links with questionable domestic fundamentals and policies, such as Turkey, are being hit particularly hard.

With the global credit cycle turning, the Fed’s adherence to the traditional modus operandi of monetary policy could backfire in two ways.

First, sticking to the plan of further rate rises laid out in the FOMC’s dot plot risks instigating a “dollar doom loop”. The currency could continue to appreciate, putting further downward pressure not just on emerging market assets and economies, but on banks and exporters in countries with significant exposure to EM such as Europe.

What’s more, a further divergence between the economic performance of the US and the rest of the world would push the dollar even higher. At some stage, this would feed back negatively into the US corporate sector via lower energy prices that tend to fall when the dollar appreciates.

Second, an even stronger dollar would likely provoke more than critical tweets from Donald Trump. Given the US president’s focus on the trade deficit, which would eventually risk widening in response to an excessively strong US currency, the administration could deliver more protectionist policies. It might even resort to currency intervention to weaken the dollar using the US Treasury’s Exchange Stabilization Fund, creating a conflict with the Fed’s monetary policy intentions.

An obvious option for the Fed is to pause or finish raising rates in September in an effort to stem the appreciation of the dollar. This would reduce the incentive for the US administration to engage in a full-blown trade war or intervene in the foreign exchange market. The risk with this option is that an economy already turbo-charged by fiscal stimulus, and close to full employment, rapidly overheats. What’s more, many market participants might conclude that Mr Trump’s intervention via his Twitter posts has had an impact on policymakers and compromised the Fed’s credibility.

Faced with these two alternatives and the unpleasant consequences they carry, the most likely outcome is that the Fed raises rates in September but signals that it stands ready to slow down if global uncertainties and the dollar appreciation intensify. Whether such a dovish rate rise would be enough to calm the EM rout and cap the dollar’s upward trajectory is unclear.

A more effective response would be to revive the use of the Fed’s balance sheet as a more active tool. In practical terms this would mean an end to rate rises — or at the very least signalling a meaningful slowdown in the pace of future increases — but at the same time accelerating the speed at which the Fed is shrinking its balance sheet.

This would change how monetary accommodation is being withdrawn rather than changing the overall thrust of the policy. This could slow the dollar’s appreciation or even reverse it as the gap in interest rates with the rest of the world would widen by less.

Given that Mr Powell and colleagues spent much time arguing that interest rate increases are the primary tool of removing accommodation and balance sheet reduction should be like watching paint dry, the Fed will probably pass on this option. However, an unprecedented situation with a mountain of dollar debt in the global system and a trigger-happy president in the White House may require unconventional responses from the world’s leading central bank.


Joachim Fels is a managing director and global economic adviser at Pimco in Newport Beach


The US and China Dig in on Trade

The trade war will only get bloodier from here.

By Phillip Orchard    

   

The U.S.-China trade war isn’t going away. Last week, U.S. Treasury Secretary Steven Mnuchin reportedly invited China to Washing to give talks another go, ostensibly to avoid another escalation. Sure, political calculations may lead to symbolic concessions or a temporary truce. Yet both sides have basically given up on trying to strike a comprehensive deal anytime soon and appear to be digging in for the long haul, Mnuchin's outreach notwithstanding. The U.S. thinks it’s in prime position to strike on trade issues and strategic matters alike. To China, the U.S. is demanding nothing less than an abandonment of the state-led economic model underpinning its rise – and the Communist Party’s hold on power. It believes the costs are not yet high enough for a dramatic overhaul. Put differently, the trade war is will only get bloodier from here. How it plays out, though, will depend on which of the two different types of trade wars the U.S. decides to fight.
 
State of Play
The U.S. currently has 25 percent tariffs targeting around $50 billion in imports from China in effect. On Sept. 6, the public consultation period on another $200 billion in U.S. tariffs, now expected to be 10 percent, came to a close, meaning the White House can order implementation at any time. (The Wall Street Journal reported that the order will go ahead once the administration can make revisions based on the public feedback it received.) On Sept. 7, President Donald Trump threatened tariffs on yet another $267 billion worth of Chinese goods – effectively meaning all Chinese exports to the U.S. would be taxed.

China has responded dollar to dollar thus far, but with China’s imports of U.S. goods last year amounting to just $154 billion, it won’t be able to continue if the White House follows through with the third round. (It has pledged to retaliate against as much as $110 billion, or 85 percent of U.S. exports.) China will have to try to level the playing field in other ways, such as filing complaints with the World Trade Organization, encouraging consumer boycotts of U.S. goods, and making life miserable for U.S. firms operating in China. A new survey by the American Chamber of Commerce in Shanghai, for example, found that more than half the U.S. firms in the country are already facing non-tariff barriers such as increased regulatory scrutiny and customs delays. (There are limits to what China can do without alienating foreign investors.)

The U.S. is sticking to its guns for three main reasons. First, the White House thinks it's in position to push for far more than a modest deal that narrows the U.S. trade deficit and perhaps brings about some measure of reform in China. Such a deal could have been reached months ago and given Trump a tangible victory. In fact, Chinese negotiators reportedly thought such a deal had been reached in May, when China agreed to dramatically boost agriculture and energy imports, only to see it fall apart less than a week later because of disagreements within the White House. Meanwhile, the U.S. trade deficit has only grown, rising by 9.5 percent month-over-month in July alone.

The White House thinks it can fundamentally restructure the U.S. trade relationship with China. Numerous aspects of the Chinese model are in the crosshairs, from market protections to state support for rival industries to alleged support for forced technology transfer and outright theft. And even though Trump’s focus on the trade deficit – which is, in many ways, a measure of the strength of the U.S. economy – isn’t exactly popular, these other components have substantial bipartisan support. The fight over them will continue regardless of the outcome in the next two elections.

Second, near-term political and economic pressures are not forcing the White House to compromise. China’s original strategy rested on the hope that the pain from the trade war would make it politically untenable for Trump. This strategy involved targeting politically sensitive districts and industries in swing districts with Chinese counter-tariffs and informal trade barriers. As China’s consumer base has grown, U.S. exports have as well, with goods to China alone surging by 86 percent over the past decade (compared to 21 percent for the rest of the world). Beijing also expected that U.S. tariffs would create some friendly fire. According to a study by the Peterson Institute for International Economics, for example, the first $50 billion in U.S. tariffs would harm foreign firms in China – many of them American – more than Chinese firms. Costs of component parts that U.S.-based manufacturers relied upon would go up. New U.S. tariffs targeting finished goods would make the sticker shock more apparent, reminding voters that tariffs are a tax shouldered primarily by consumers. The interconnectivity of multinational supply chains today simply makes it difficult to target one country without hitting others.

Some degree of political backlash in the U.S. is certainly taking place. There is a growing chorus of warnings from trade groups, industry associations and anxious lawmakers about the economic fallout to come. A group representing thousands of companies known as Tariffs Hurt the Heartland is the latest to raise a stink. The decision to reduce the next round of tariffs to 10 percent, rather than 25 percent as ordered by Trump in July, may hint at a degree of concern about exposing U.S. consumers to steep price hikes so close to a pivotal election. Yet, at this point, there’s little evidence to suggest that trade, inherently an esoteric issue, will dominate the midterms. The U.S. economy is too strong, and the pain from the trade spat either too sectoral or too theoretical at this point, to have a tangible impact on most voters’ lives in the next few months. (Besides, some sectors and communities stand to benefit.)

Finally, there are much bigger strategic issues at play, from North Korea to the South and East China seas to the broader aim of curbing Chinese influence. And with trade, the White House thinks it has Beijing on the ropes. It’s hitting China at a precarious time, forcing Beijing to fight a two-front war against Washington on trade and against deeply embedded economic problems. Beijing is scrambling to help small exporters, particularly through boosted lending and tax relief. In China, the stakes of an economic slowdown are an order of magnitude higher than in the United States. The White House has good reason to think it has the upper hand.
 
China Shifts to a Containment Strategy
China just doesn’t have much room to give. The biggest reason is it can’t meet the United States’ demands on issues like structural changes and market reforms. Doing so would be tantamount to abandoning its core industrial and development models – the way it asserts central authority across the country, its means of addressing imbalances between the coasts and the interior, its state-led drive to move up the manufacturing value chain and compete in high-tech industries, and so forth. Chinese officials say these issues account for as much as 40 percent of U.S. demands. If anything, the trade war is convincing Beijing that it needs to accelerate its plans to boost domestic industry and reduce dependence on the West.

Nor can China agree to measures that would do real damage to the trade imbalance, particularly liberalizing its currency. Japan’s “Lost Decades” – themselves partly the result of similar U.S. pressure to strengthen a currency – taught China a lesson in how detrimental it can be to give into sweeping U.S. trade demands. Japan has the societal cohesiveness to survive a 20-year slump without major social upheaval. China cannot be sure it does.

Ultimately, Beijing may get pushed to the point where it has to start conceding on things it thought it never would. But doing so now might be premature for two main reasons. The first is the state of U.S. politics. Even though the pressure on issues like technology theft won’t go away with the next U.S. administration, Beijing has reason to believe the U.S. will struggle to maintain that pressure if there's political chaos in Washington. Second, Beijing thinks that the economy is on solid enough footing to ride out the storm for now – and that it has enough tools available to offset some of the pain. (It can quickly channel credit to and ease tax burdens on affected industries, its ability to modestly weaken the yuan, etc.) The economy is relying less and less on exports and more on state-directed investment and domestic consumption.

Still, the trade war is making Beijing nervous. Even without the trade war, Beijing has been walking a tightrope as it attempts massive reforms to restructure the economy amid slowed growth, without sparking mass social unrest. Losing exports to the U.S. will give it a lower margin for error. Moreover, there’s only so much Beijing can anticipate. It’s impossible to comprehensively map out the effects of the trade war, in part because it’s unclear what new tariffs will be implemented, what exceptions either government will carve out and what measures either side will take to offset the pain. Global supply chains will shift at varying speeds. As China’s retired central bank chief noted this week, perhaps the biggest unknown is the potential for panic. So Beijing has little choice but to prepare for worst-case scenarios.

For China, that scenario is that other major economies – especially Japan and Europe – form a united front with the United States. Beijing believes it can withstand lost exports so long as business can continue as usual with the rest of the world. If the world gangs up on China, that's a different story. Indeed, there are some signs that Japan and Europe are putting aside their own trade differences with the U.S. to, for example, join U.S. cases against China at the WTO and adopting measures to to restrict Chinese investment in local firms. As a result, Beijing has opened a major charm offensive, taking several steps to ease tension with Tokyo and going hat in hand to Europe.

Thus, to an extent, how the trade war plays out boils down to what kind of trade war the U.S. chooses to fight. If the goal is to contain China – economically but also strategically by diminishing its ability to modernize its military and buy friends and allies – then Beijing will find itself in a serious fix. If the goal is to bring back manufacturing jobs lost to foreign competition, then Trump can’t stop with China. Labor-intensive manufacturing operations in China would simply move to other low-cost destinations rather than home to the U.S., while higher-end manufacturing would still face stiff competition from Europe, Japan and South Korea. A united front will be more difficult to form, and China might just be able to find a way through unscathed.


A Hindenburg Omen is forming in the stock market. Should investors ignore it?

More new lows than new highs despite big gains in the market indexes warns that breadth is deteriorating

By Mark DeCambre
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Courtesy Everett Collection
HINDENBURG, Burgess Meredith, Anne Bancroft, William Atherton, 1975


The Hindenburg Omen is materializing in the stock market, raising hackles among some market participants who closely watch for patterns that may portend ill for a stock market that has been knocking on the door to fresh highs.

Named after the German dirigible that notoriously exploded in 1937, the Hindenburg Omen is formulated to predict market crashes, or severe downturns, by synthesizing data, including 52-week highs and lows as well stock moving averages on the New York Stock Exchange. It was created by Jim Miekka, a blind mathematician, marksman and teacher, who died about four years ago. Miekka claimed that his indicator had been an accurate predictor of every market crash since 1987 on.

But as a number of market participants have noted, an appearance of the so-called Hindenburg Omen, hasn’t always resulted in an unraveling of the equity market.

A jump in the number of stocks hitting 52-week lows and highs on the New York Stock Exchange has been a key feature, among others, used to calculate the bearish pattern. Jason Goepfert, president of Sundial Capital Research, highlighted in a recent note cited by Bloomberg News that he has observed a clutch of such high/low moves on the NYSE and the Nasdaq, which can signal a degree of market indecision that can result in a broader market break down.

On Sept. 11, for one, there were 121 new 52-week lows put in on the NYSE, compared with 95 highs, Dow Jones market data show, despite healthy gains in the major market indexes.

A market’s propensity to produce more new lows than new highs suggests that market breadth is deteriorating, which can also be interpreted as a warning sign in stocks.


Bearish market predictions come as the S&P 500 index SPX, -0.24%is within shouting distance of a fresh record above 2,914, while the Nasdaq Composite Index COMP, -0.77%and the Dow Jones Industrial Average DJIA, -0.04% have been in an uptrend, albeit a tenuous one that has been vulnerable to rhetoric related to concerns centered on trade relations between the U.S. and China.

The Hindenburg Omen, however, has produced a spotty record, lately.

Prominent technical analyst Tom McClellan told MarketWatch’s Tomi Kilgore back in 2014 when another Omen appeared that “there are far more Hindenburg signals than there are scary declines.”

McClellan told MarketWatch on Friday that he has seen a cluster of 7 Hindenburg instances, including on Friday (before the close), in which 52-week highs and 52-week lows were more than 2.8% of the total of advancers plus declining shares, one key feature of the omen (see chart below):  
McClellan told MarketWatch that such clusters “matter more than individual signals.”

However, he said “they are not a guarantee that trouble has to come, just a warning that things are getting hinky in a way that has mattered before.”

A Hindenburg Omen back in August of 2017 formed and was spotted by Goepfert but didn’t amount to much either.

Mark Arbeter, technical analyst at Arbeter Investments LLC, said more context is usually required to genuinely interpret the bearish-sounding formation.

Arbeter wrote in a research note on Sept. 13:

It seems like spurious reasoning to me that if there are a fair amount of new highs as well as new lows, that this is bearish. There can be instances when the overall market is doing well and one sector is really weak, leading to many new 52-week lows. It happens as each individual sector is driven by its own fundamentals. Now if we see many stocks from many sectors hitting new 52-week lows, then there might be trouble ahead.

Miekka recommended caution when thinking about his own indicator, likening it in a 2010 interview with The Wall Street Journal before his death to “sort of like a funnel cloud.” He said “it doesn’t mean it is going to crash.” However, he suggested that there may be a high probability that the market is headed for a fall. “You don’t get a tornado without a funnel cloud.”

Sometimes it is hard to ignore such patterns like the Hindenburg or the Ohama Titanic Syndrome but they have thus far been poor predictors of stock-market collapses. To be sure, even a broken clock is right twice a day.


Trump, Dimon, and the Financial Crisis

By Randall W. Forsyth   
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Trump, Dimon, and the Financial Crisis
Photo: Marlene Awaad/Bloomberg 


In a week marking the 10th anniversary of the signal event of the financial crisis, who would have guessed the most amusing and inadvertently enlightening event would be a tiff between America’s preeminent banker and America’s chief executive?

Representing the lending side was JPMorgan Chase CEO Jamie Dimon. President Donald Trump heads the world’s biggest borrower, the U.S. government, and has more than a little experience with debt from his days as a real estate developer and casino operator. “I think I could beat Trump,” Dimon said of a match-up for president. He claimed to be as tough as Trump and “smarter than he is.” To top that off, Dimon added, “this wealthy New Yorker actually earned his money. It wasn’t a gift from Daddy,” alluding to the seed money that Trump received from his wealthy developer father.
Trump, of course, couldn’t let that go, tweeting that Dimon is unsuited to run for president since he “doesn’t have the aptitude or ‘smarts’ & is a poor public speaker & a nervous mess—otherwise he is wonderful.”


There’s a certain irony that, a decade on from the worst credit crisis in history, high-profile representatives of the financial class are at the pinnacle of the world’s power elite. What might be as surprising is that nobody has gone to jail over the criminal acts that brought on the crisis, from making fraudulent loans to the Wall Street machine that turned toxic mortgages into gilt-edged AAA securities.


The main narrative also remains that policy makers, from the Treasury to the Federal Reserve, did everything in their power to fight the crisis. To this day, officials (including former Treasury Secretary Henry Paulson contend that they couldn’t have prevented the demise of Lehman Brothers, the signature failure of the crisis.

That assertion is countered by Johns Hopkins economist Laurence Ball in his recent book, The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster, in which he argues that Lehman had sufficient collateral to secure a loan from the Fed that could have saved it. The day after the Lehman bankruptcy, the Fed would rescue AIG, whose failure potentially could have had even more disastrous consequences.

The recovery since the crisis has largely been the product of the unprecedented monetary policies adopted to fight the downturn. Even more extraordinary is that these policies persist. Deutsche Bankstrategists point out that 25% of the world’s economy still has negative interest rates. And the balance sheets of the Fed, the European Central Bank, and the Bank of Japan—which more than quadrupled in size from their levels before the crisis, to a combined $14.5 trillion—will only begin to fall in aggregate later this year.

The Fed under Jerome Powell is increasingly focused on these policies’ role in inflating financial bubbles. He has noted that the past two recessions have followed financial excesses: the housing bubble that led to the financial crisis of 2008, and the tech-stock bubble that burst in 2000.

Concern about financial excesses is spreading among central bank officials. In a speech last week, Fed Gov. Lael Brainard expanded on that theme: “The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed in financial-sector imbalances, rather than accelerating inflation.”

Brainard previously had been a dove, supporting the go-slow policy on rate hikes under former Fed Chair Janet Yellen, who, in a speech Friday, counseled letting the economy boom to make up for the previous bust.

“This is not the Yellen academic Fed,” Gluskin Sheff chief economist and strategist David Rosenberg writes. Its past mistake has been to focus strictly on its dual mandates of stable inflation and low unemployment, without regard to financial excesses. In that regard, the Fed sees equities as expensive and corporate bond spreads as tight, he adds.

While the markets lurch up and down on the latest tariff headlines, it’s all but certain that the U.S. central bank will be removing accommodation by hiking interest rates, while continuing to shrink its balance sheet. There’s a 97.5% probability of a quarter-point boost in the federal-funds target rate, from 1.75% to 2% currently, at the Fed’s next policy meeting concluding Sept. 26, according to Bloomberg. The chance of an additional quarter-point move on Dec. 19 has risen to 79.2%.

In other words, this Fed aims to avoid stoking the excesses that led to past crises. And to leave the excesses to bloviating bankers and presidents.


NAFTA by Any Other Name

The negotiations with Mexico have ended. Talks with Canada will now begin.

By Jacob L. Shapiro


The United States and Mexico have reached an agreement to revamp the North American Free Trade Agreement. The governments were short on the details, but one thing that is certain is that Washington would like to change the pact’s name to “The United States-Mexico Trade Agreement.”

Noticeably absent from this name is Canada. Mexico has said it hopes Canada will join, but what Mexico hopes for is irrelevant. This now comes down to whether Canada and the U.S. can work out their bilateral issues in the same way Mexico and the U.S. just did.

NAFTA is a trilateral agreement in name. It’s better thought of as two distinct bilateral economic relationships: one between the U.S. and Canada, and one between the U.S. and Mexico. Mexico and Canada simply don’t trade that much with each other. Canada imported more from China in 2017 than it did from Mexico, and just 1.4 percent of its exports went to Mexico. Just under 3 percent of Mexico’s exports went to Canada, and just over 2 percent of its imports came from Canada. And though Canada and Mexico have some interests in common, overall, the trade issues at stake are different for both sides. What Mexico negotiates with the U.S. on, say, fruit exports has little to do with what Canada negotiates with the U.S. on dairy exports. 

(click to enlarge)



It is little wonder, then, that the trilateral format of NAFTA negotiations broke down in May. Shortly thereafter, the U.S. and Mexico began negotiating directly with each other. (There were concerns that the election of Andres Manuel Lopez Obrador could derail U.S.-Mexico relations. They were misplaced.) Since then, the U.S. and Mexico have whittled away at their disagreements. The U.S. softened its stance on including a “sunset clause” to force new negotiations every five years. Mexico conceded on auto content regulations, agreeing to increase the percentage of auto content made in the U.S. and Mexico to 75 percent from 62.5 percent and requiring 45 percent of auto content to be made by workers making at least $16 an hour.

If recent trade relations are any indication, talks with Canada promise to be more contentious.

Canada’s official response to today’s announcement was stately; its foreign minister said that such a deal was a “necessary requirement for any renewed NAFTA agreement.” But beneath this veneer of pleasantries, one of the main fault lines is already clear: Canada is still talking about NAFTA, and the U.S. is not. The U.S. and Canada have been butting heads publicly ever since Washington denied Canada an exemption from steel and aluminum tariffs earlier this year. Ottawa responded with almost $13 billion worth of tariffs on U.S. goods of its own.

There are, of course, domestic political considerations to today’s announcement. By changing the name of the agreement, President Donald Trump can show his base that he fulfilled his promise to “rip up” NAFTA when he got to office, even if its fundamentals remain in place. But this is about more than domestic politics. Today’s press conference didn’t just mark the end of U.S.-Mexico negotiations – they also marked the beginning of U.S.-Canada negotiations.
It sets Washington’s opening position. By publicly announcing an understanding with Mexico, the U.S. pressures Canada to fall in line. Either “negotiate fairly,” in the words of Trump, or walk away, or so the thinking goes.

In the end, the importance of bilateral trade between Canada and the U.S. will force both sides to compromise, much like how it did with the U.S. and Mexico. The negotiations won’t be pretty, but NAFTA will survive in some form or another, regardless of whatever new name (or names) it is given. Today’s announcement shows that the U.S. is open to compromise but also willing to walk away from the table. Canada can’t afford to walk. Let the bargaining begin.