Conclusion: The growing divide in monetary policy relative to the US suggests current FX trends may continue and perpetuate crude oil prices beyond their summer ’08 peak. At the bare minimum, elevated prices are here to stay over the intermediate-term TREND – irrespective of the turmoil in the Middle East and North Africa.
Position: We remain long of inflation via crude oil, gold, agricultural commodities, and energy stocks. We remain short bonds, emerging markets, and US consumer and industrial stocks.
Perhaps the most important piece of economic data to hit our screens in recent weeks is ECB President Jean-Claude Trichet’s hawkish comments following the latest ECB policy meeting last Thursday. Regarding those comments, Matt Hedrick, our European Analyst writes:
“In a Q&A session after the ECB announced no change to its key interest rates this morning, ECB President Jean-ClaudeTrichet said that an “increase of interest rates in the next meeting is possible… but not certain.” Despite all attempts by Trichet to be close-lipped on future actions by the governing council, the sentence was largely interpreted by the market as proof that the ECB will hike in the near-term.
And both the EUR and European equity markets cheered on the news. The EUR-USD rose to an intraday high of $1.3966 and European equity indices gained to close up +50 to 150bps today.
Trichet also made it clear that today’s decision was based on data taken from mid-February, and therefore did not include the recent move in crude prices, which created further speculation that greater inflationary readings next month may boost the probability of an interest rate hike.”
Regarding these rising inflation expectations, Matt writes:
“In comments today, Trichet said the range for Eurozone inflation (CPI) has shifted upwards to between 2.0% and 2.6% in 2011 and between 1.0% and 2.4% in 2012, mainly due to “the considerable rise in energy and food prices.””
It has long been our stance that Bernanke & Co. will continue to be willfully blind to inflation pressures, as neither $100-plus crude oil or world food prices at all-time highs directly manifest themselves in the Fed’s preferred “Core” CPI reading. While refraining from the debate on the analytical merits of “core” vs. “headline” inflation, the key takeaway here is that the ECB just confirmed that they’ll be quicker than the Fed to react to rising inflationary pressures resulting from commodity inflation.
The ECB now joins the Bank of England, the Bank of Canada, Sweden’s Risbank, and the Swiss National Bank as key constituents of the US dollar basket that are exhibiting hawkish monetary policy on a relative basis to the Fed. Together, these currencies make up 86.4% of the US Dollar Index.
As we often say, “everything that matters in Macro occurs on the margin”, and, on the margin, the foreign central banks most important to determining the value of the US dollar are moving away from Bernanke & Co. on monetary policy.
As a result of this collective marginal shift in monetary policy, these currencies are appreciating relative to the US dollar:
- Euro (57.6%) of DXY: +9.5% since Aug 27;
- British Pound (11.9%) of DXY: +4.3% since Aug 27;
- Canadian Dollar (9.1%) of DXY: +8.1% since Aug 27;
- Swedish Krona (4.2%) of DXY: +15.5% since Aug 27;
- Swiss Franc (3.6%) of DXY: +11% since Aug 27; and
- Weighted average appreciation since Jackson Hole: +8.5%.
Understanding that currencies can only appreciate/depreciate relative to each other, it’s no coincidence that the US Dollar Index is down (-7.7%) over the same duration. The effect of monetary and fiscal policy on currencies does not happen in a vacuum; all deltas and inflection points must be considered relative to competing currencies.
Up until last week, it can be strongly argued that the dollar’s decline has been aided by a confluence of dovish US monetary policy (QE2) and incredibly lax fiscal policy (the CBO revised up the US federal budget deficit by +46% through FY13). With this news largely baked into the cake, we argue that incremental US dollar weakness (down -2.7% since it rallied to a lower-high in mid-Feb) is being driven largely by strength in the dollar’s counterparts, rather than incrementally-weak policy home:
- Euro (57.6%) of DXY: +3.6% since Feb 14;
- British Pound (11.9%) of DXY: +1% since Feb 14;
- Canadian Dollar (9.1%) of DXY: +1.7% since Feb 14;
- Swedish Krona (4.2%) of DXY: +2% since Feb 14;
- Swiss Franc (3.6%) of DXY: +4.7% since Feb 14; and
- Weighted average appreciation since mid-Feb: +3%.
The chart below shows the inverse relationship between the US Dollar Index and strength/weakness in its constituent counterparts (ex-Japan):
It’s no coincidence that mid-Feb corresponds with the latest jump in global crude oil prices, which have an incredibly high inverse correlation to the US Dollar Index:
- Brent: +11.1% since Feb 14 with an inverse correlation of -0.90 (r² = 0.81) on an immediate-term TRADE basis; and
- WTI: +18.2% since Feb 14 with an inverse correlation of -0.93 (r² = 0.87) on an immediate-term TRADE basis.
This price action underscores a developing trend we see picking up steam over the near term: increased hawkishness relative to the Fed out of the central banks within the US dollar basket as a result of rising crude oil prices will put upward pressure on their currencies and incremental downward pressure on the US Dollar Index – in addition to the USD’s own dovish fundamentals. Perhaps the most alarming part of this trend is that it has a self-perpetuating tendency:
- Crude Oil up;
- Increased hawkishness out of the ECB, BoE, BoC, Risbank, and SNB;
- Euro, Pound, Canadian Dollar, Swedish Krona, and Swiss Franc up;
- US Dollar Index down;
- Crude Oil up;
- Rinse & repeat.
Indeed, this self-perpetuation of global FX trends vividly reminds us of early 2008, where the monetary policy backing each of these currencies was hawkish relative to the Fed (with the notable exception of Canada, which was more impacted by the US’s burgeoning recession). Even the Bank of England, which was cutting rates at the start of 2008, was more hawkish than the Fed by cutting at a significantly slower pace. The ECB and the SNB were on hold after hiking rates in mid-to-late 2007 and the Riksbank was outright raising rates until September of 2008.
This collective hawkishness relative to the Fed from mid-to-late ‘07 through mid-2008 contributed to widening interest rate differentials across the board, as the spread between German, British, Canadian, Swedish, and Swiss 2Y bonds each increased vs. 2Y US Treasury bond yields (using German bunds as a benchmark for EU yields). This widening of spreads supported the appreciation of each currency (Euro, Pound, Canadian Dollar, Swedish Krona, and Swiss Franc) vs. the USD.
Understanding full well that the Fed did its best to debauch the dollar during this period, the US dollar would not have declined much without the aid of this relative hawkishness out of competing central banks – the buck can’t truly burn without help. Thus, as each currency appreciated relative to the USD, the US Dollar Index correspondingly depreciated. Given, we argue that much of the run-up in crude oil prices from late-2007 to mid-2008 was, in fact, due to strength in the USD’s counterparts as much as it was due to Bernanke Burning the Buck.
Fast forward to 2011, and we have a very similar scenario whereby competing central banks are getting tighter on the margin relative to the Fed by a combination of hawkish rhetoric and rate hikes. This marginal hawkishness is supporting each of their currencies to varying degrees (excluding Japan, which continues to hint at additional easing, but is handcuffed by rising import prices) and keeping the selling pressure on the US dollar, which keeps buying pressure on crude oil and other commodities.
While the US Dollar Index may be oversold on an immediate-term TRADE basis, the broader intermediate-term TREND suggests that this self-perpetuating cycle is already underway and will only be alleviated by some combination of dovishness out of the aforementioned foreign central banks or hawkishness out of the Fed from a policy perspective – which is unlikely given that Bernanke was unable to see inflation at $150/bbl. crude oil; nor could he hike rates when GDP growth was at +5% on an annualized basis.
We know QE2 is ending in three months; will the Fed be tempted to step on the gas pedal some more? Reasonably strong US GDP growth forecasts of around +3.5% for 2H11 suggest that QE3 is not consensus – yet. If, however, we are correct in our call for a measured rollover in consumption growth and expedited housing deflation over the intermediate-term TREND, calls for additional monetary easing in the US will indeed become consensus – making US monetary policy incrementally dovish vs. competing central banks, as well as giving the US dollar an incremental push to the downside relative to its counterparts.
Of course, the Eurozone continues to have its sovereign debt issues, so we’ll be acutely focused on their monetary policy as well, measuring the slope of any hawkishness or dovishness on the margin. For now, their relative hawkishness combined with that of the BoE, BoC, Riksbank, and SNB is supporting the price of crude oil, which, ironically, supports additional hawkishness.
Will the cycle extend itself as it did in early 2008? As always, time and space will tell.