Crème Dollar Crème
John Connolly, US Secretary of State for the Treasury during the Nixon administration, famously said during a G-10 meeting in 1971 that, “the dollar is our currency, but it’s your problem.” He was speaking in the wake of the suspension of dollar-gold convertibility in August of that year, and he had in mind the readjusting the dollar’s exchange rate lower in order to improve America’s terms of trade.
In 2022, faced with the first meaningful surge in inflation in well over a decade, the US Federal Reserve may well find that this time around, the dollar is in fact its problem as well as everyone elses’. The Fed clearly got inflation wrong in 2021, describing it as transitory when it was sticky. Chairman Jay Powell has always claimed that Fed had the toolkit to deal with inflation. 2022 is the year we actually find out how many tools there are at the Fed.
US CPI inflation touched 6.8% in November 2021, and the Fed is now clearly playing catch-up. When the most recent Federal Open Market Committee (FOMC) minutes were released on the 5th January 2022, the market took fright that the Fed seemed more hawkish than anticipated, particularly at the hint that the Fed may actually start to reduce the size of its balance sheet after the end of quantitative easing (QE) in March. It is unclear whether this will be selling bonds (otherwise known as quantitative tightening or QT), or letting bonds ‘roll off’ their balance sheet when the mature. In fact it’s unclear if they’ll really do this at all.
Markets are now pricing a 70% chance of a March 2022 Fed rate hike, with as many as 3 further hikes being priced for 2022. With such upward pressure on Fed Funds rates, bond yields have started to rise in 2022. Ominously, equities and bonds have increasingly started to move in tandem. While the S&P 500 is still near its all-time high, under the hood, the more bubbly elements of the equity market have been struggling for some time. There is no coincidence that this adjustment started to happen just as the Fed began to sound more hawkish.
The effect of the Fed continuing with QE long after the growth and inflation backdrop for the US economy warranted has led to bubbles appearing in the equity market, the credit market, and by the end of 2021, in the housing market as well. There has been an excess of liquidity. Another consequence of getting inflation wrong is that the Fed will be tightening into a fiscal cliff in 2022. The US 2021 fiscal deficit will likely prove to have been around $3 trillion, and this is falling to ‘just’ $1.2 trillion in 2022. Many of the tailwinds which have pushed consumption in the past 18 months will turn into reverse even as higher prices are increasingly providing a headwind to US consumer confidence. US corporate earnings will likely be adversely affected by this too.
The sign that the monetary and fiscal tide is changing can be witnessed in the US Dollar. The graph below shows the DXY dollar index and its long, steady rally from around 90 in June 2021 when the Fed announced its intention to taper to its current levels around 96.
With the Fed moving into hiking mode, much of the dollar strength is coming from euro and increasingly yen weakness. The ECB’s anti rate-hike stance in 2022 seems especially egregious given Eurozone CPI inflation in December 2021 was 5.0%. Yet neither the ECB nor the Bank of Japan seem inclined to hike rates this year.
The combination of rising yields and falling liquidity played havoc on the market in the latter half of 2018, and again it is no coincidence that this was the last time the Fed was acting (rather than just talking) in a hawkish manner. Having inflated an asset bubble by delaying the end of QE and starting rate hikes in 2021 or even late 2020, The Fed is responding late to the fact that the US pandemic response in Q2 2020 was in fact a gross over-response, and that the fiscal largesse, monetised by the Fed, has radically changed the short-term inflation outlook.
The Fed’s choice has been clear for some time, and it is a Hobson’s choice of their own making. Fight inflation and wreck the financial markets during a slowdown in the economic cycle, or defend asset prices (especially US Treasury prices) and sacrifice the dollar to inflation. The US has form on this - in the crises of 1932 and 1971, the dollar was devalued to save the economy. This time it’s different?
Whether the Fed is just having a play-date with hawkishness or whether it really means it will dictate the direction of the dollar in 2022, and likely with it the direction of financial markets and to a great extent the global economy. At another meeting of finance ministers about global exchange rates late in 1971, John Connolly said, “We had a problem and we are sharing it with the world, just like we shared our prosperity. That’s what friends are for.” Plus ça change.