A RISING DOLLAR LOWERS U.S. INFLATION BY PUSHING COMMODITY PRICES LOWER -- FALLING EUROPEAN CURRENCIES ARE PUSHING THE DOLLAR HIGHER -- FALLING BOND YIELDS IN THE UK AND EUROZONE ARE PULLING TREASURY YIELDS DOWN -- 10-YEAR BOND YIELD DROPS BELOW 2.00%
A RISING DOLLAR IS KEEPING COMMODITY INFLATION DOWN...One of the reasons given by the Fed for lowering rates yesterday was to boost inflation. But the dollar hit the highest level in a year right after the rate cut. That's because foreign central bankers in Asia and Europe are lowering rates even faster, or are threatening to do so. In other words, the Fed is behind the global trend toward lower rates. That can be seen most clearly in their respective currencies. While the British Pound and the Euro have fallen to the lowest level in two years, the U.S. Dollar Index has hit the highest level in a year. It looks like everyone is trying to weaken their currency in an attempt boost stubbornly low inflation. The fact that the dollar is the strongest currency in the developed world is going to make the Fed's job much harder. That's because a rising dollar lowers U.S. inflation.
The monthly bars in Chart 1 compare the U.S. Dollar Index (green bars) to the CRB Commodity Index (brown bars) over the last two decades. It's pretty clear that they usually trend in the opposite directions. The last big commodity rally between 2002 and 2008 was fueled by a plunging dollar. The mid-2008 commodity peak was largely caused by a major upturn in the dollar that same year (see arrows). The next dollar upturn during the second half of 2011 contributed to another big downturn in commodity prices. That dollar rally that began in 2011 has been the main reason that commodity prices have remained so low over the past decade. And that has contributed to persistently low inflation. The 60-month Correlation Coefficient in the lower box shows a negative correlation of -0.66 between the two over those two decades. That's pretty convincing evidence that the direction of the U.S. dollar plays a major role in U.S. inflation. And why a rising dollar won't boost U.S. inflation. A rising dollar over the past year has weakened commodities even further (see arrows and trendlines). But the Fed doesn't seem to pay much attention to that.
Several times over the past few years heads of the Fed have claimed that low inflation was "transitory" in nature. Mr. Powell made that claim just a few months ago. I challenged that claim by showing a chart similar to the one in Chart 1 to make the point that a decade of falling prices isn't "transitory". The Fed filters out food and energy prices in their inflation forecasts. Which probably explains why it's been so wrong for so long. And why it's likely to be wrong again. Especially if its policies keep pushing the dollar higher.
THE PROBLEM IS FALLING FOREIGN CURRENCIES...The most obvious reason the dollar has been so strong over the past decade is because major foreign currencies have been so weak. Three of the biggest ones are shown below. The two biggest losers since 2008, and again since 2011, have been the British Pound (red bars) and the Euro (blue bars). They're the two biggest contributors to the dollar rally over the last five years. The orange area plots the Japanese yen which peaked in 2011 and bottomed in 2015. The yen led the decline against the dollar between 2011 and 2015. But has held up better over the last four years. [You'll see why shortly]. Which suggests that the bigger problem right now for the U.S. dollar is falling European rates.
FOREIGN RATES ARE PULLING THE US LOWER...Chart 3 compares 10-Year bond yields over the last ten years for the U.S., Britain, German, and Japan. And they largely explain why foreign currencies have been so much weaker; and the dollar so much stronger over the past decade. The solid area shows that Japanese rates started the decade much lower than everyone else. Japan has been in a losing battle against deflation for the last two decades by keeping rates low in the hope of weakening the yen (and boosting inflation). That helps explain why the yen in Chart 2 fell much faster than European currencies between 2011 and 2014.
During 2014, however, the German yield starting dropping sharply (blue arrow) which started the slide in the euro that year in Chart 2. The British yield started falling sharply during 2015 and 2016 (red arrow) which pulled the pound lower. The fact that they both fell more than Treasuries explains why their currencies weakened more; and the dollar held up better. That's when the U.S. Dollar Index in Chart 1 turned up; and commodities began their latest slide (green circle in Chart 1). The fact that Japanese yields were already so low, and have been relatively flat over the last four years, explains why the yen has held up better than the other three currencies (including the dollar) since 2015. Relative strength in the yen may provoke more monetary stimulus from Japan (if that's possible). The last thing the BOJ wants now is a stronger yen which hurts exports and weakens inflation.
All of which explains why the Fed is now placing so much importance on foreign markets. It has no choice. Weakness in foreign economies is causing foreign rates to fall faster than the U.S. That in turn acts as a drag on Treasury yields. Falling German yields may be having more of an impact on falling Treasury yields than the Fed. Weaker foreign currencies are boosting the dollar which is keeping U.S. inflation down. The only way the Fed can prevent that is by lowering rates a lot more. Which it seems reluctant to do in the fact of a relatively strong U.S. economy. And to keep some ammunition for when the real economic slowdown finally does arrive.
STOCKS REBOUND WHILE BOND YIELDS DROP...Stocks are rebounding strongly today after yesterday's brief selloff. While the Fed may have left us confused yesterday, bond traders may not think so. The 10-Year Treasury yield has fallen below 2% today and is near the lowest level of the year. The 2-year Treasury yield, however, is dropping even more (which is steepening the yield curve). That would seem to suggest that traders expect some more Fed easing to come. That may also be causing today's strong rebound in stocks. Chart 5 shows the S&P 500 Index regaining more than 1% in late morning trading. Chart 5 shows the SPX bouncing off a flat trendline drawn over its April high which is a positive sign. And its 14-day RSI line (upper box) is bouncing off the 50 line. The SPX is also trading back over its 20-day average (green line). That would be another encouraging sign if the morning rally in stocks carries through the rest of the day. Chart 5 shows the Nasdaq Composite Index having an even stronger day. A big jump in technology stocks is making the Nasdaq the day's leader. Bond prices are also rallying as yields drop. Interestingly, Treasury yields are dropping today more than in Europe. That's helping to slow the advance in the dollar.
