The US Federal Reserve flagged its decision to raise the discount rate in its January meeting. It proceeded to do so on 18 February. It reiterated that the move was not and did not signal any intent to change the monetary policy stance. It was meant to consign the discount window to its role during exceptional liquidity crises, now that there is no such need. Yet, financial markets were spooked for a while. That shows how overleveraged economies and financial markets remain sensitive to signs of tightening in the US, the country with the world’s largest reserve currency.
The Federal Reserve’s tightening efforts in 1994 led to the Mexico crisis. Its steady rise in interest rates in 1999-2000 finally deflated the technology bubble. Its gradual increase in rates during 2004-07 put paid to the notion of a “contained” housing bubble.
Hence, it is no surprise that investors jump at any hint of tightening from the Federal Reserve.
Paul Krugman is nearly certain that the US economic situation does not warrant any tightening for a few years. Should it go ahead and put interest rates up, however, he thinks that it would confirm a bias that James Galbraith documented in a paper he wrote in 2007. That is, the yield curve is steeper when Republicans are in office and flatter during Democratic administrations, indicating lower and higher rates at the short end, respectively. Based on his results, he claims a serious partisanship bias at the heart of the Federal Reserve policy-making process.
Regardless of whether there is bias or not, the Federal Reserve might not be averse to seeing some rise in volatility in stock markets. Andrew Smithers’ observations in an interview to Welling@Weeden in November were insightful: “So if we were to get the markets going up a bit more, say during 2010 into a third asset bubble, and if they were to fall again, it would be frightfully difficult to see how the result wouldn’t be very severe, in terms of recession… So it seems to me that a major aim of policy today should be to ensure that we don’t get a third leg of the asset collapse on our hands. Probably the best way of ensuring that is by making sure that asset prices simply don’t go up much more.”
If policymakers are indeed concerned about stoking a third bubble too quickly, then they would behave as he suggested. That would imply keeping the market guessing about the actual timing of the rate hike, from time to time, even if there were no real policy change.
If the economy did not recover in the US, this would be a difficult act to pull off. For now, the signs are good for such a delicate “pulling the wool” over investors’ eyes. US economic data have been reasonably strong. But sustained resilience remains uncertain.
Small businesses still face difficult times. Residential real estate foreclosures are still rising and a similar development is anticipated with respect to commercial real estate mortgages.
In the meantime, emboldened by the Democrats’ loss of filibuster-proof majority in the Senate and US President Barack Obama’s declining popularity ratings, fiscal conservatives have formed a tea-party movement. Whether they stand for prudent fiscal or economic policies is difficult to ascertain, but their hands have been strengthened by investor focus on sovereign borrowings and debt levels brought about by the situation in some European countries.
At the same time, if the economy begins to sputter, those who argue for further stimulus would regroup. One expects this year to be a year of alternating show of strength by these camps. That would dictate the prospect for the US dollar. For now, monetary policy fears and fiscal restraint ensure that, at the minimum, the dollar remains stable.
Hence, for now, it makes sense to bet on the dollar strength against the Japanese yen rather than through the euro, since the latter has depreciated significantly in recent weeks and sentiment on the euro zone is pessimistic.
It is not that investors have been optimistic on Japan, but their attention is bound to shift towards a currency that has not weakened much against the dollar this year.
However, for reasons stated above, Bare Talk does not believe that the US dollar depreciation is now history. On the contrary, dollar weakness is a pause that refreshes.
In the meantime, investors would do well to note the extraordinary resilience of the price of gold amid the so-called dollar revival. One clear trend in a year that is bound to be frustratingly directionless (in the best case) would be the rise of gold. One simply has to wait for investors to realize that neither the euro nor the dollar presents much of a choice.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org