Does China control the Fed?

It’s a central question for markets. The US economy is plodding along, not soaring, not crashing, but firming enough to push interest rates higher were it in a vacuum.

Problem is, the US central bank, the FOMC, is not operating in a vacuum. It’s enmeshed in a web of global capital flows that are themselves shifting around an earth with too much supply or too little demand (depending upon your economic poison). Thus when the Fed raises interest rates it triggers all manner of Butterfly Effects including, most obviously, capital flowing into the US dollar denominated assets from other low interest rate jurisdictions and away from dollar-funded and dependent emerging markets and commodities.

Thus, ending quantitative easing and hiking 25bps has been enough to trigger a roughly 20% rally in the US dollar and a lot more tightening than would normally be the case, not just to the US but to the wider world as capital flowed out of emerging market economies tightening credit. This was enough to drive a panicked crash in commodities and emerging market debt early this year, at which point the Fed was forced to back off from its interest rate normalisation project.

So, we might ask, who exactly is the Fed the buyer of last resort for these days? Is it for the US financial system and economy or the global financial system and economy? The answer is very important for the interest rate outlook. Gavyn Davies tackles the question at the FT:

When the FOMC increased rates last December, they seemed quite confident that the 0.25 per cent hike was the first in a long line of similar increases each quarter, driven by the need to “normalise” interest rates gradually over time.

At that stage, they also seemed fairly sure that they knew what “normal” meant. Now, they seem to have lost that certainty, and have simultaneously shifted their central assessment of the “normal” level for short rates sharply downwards. This has not surprised the markets, which moved in that direction well ahead of the FOMC. But it has strengthened the conviction among investors that the doves are now firmly in control at the Fed.

Last week, Ben Bernanke released an important blog, analysing the main reasons for the FOMC’s change of view, and largely giving his seal of approval. Although the former Fed President has of course been inclined towards dovishness ever since 2008, it is significant that he views the shift as being underpinned by deep fundamental forces inside the US economy, not by minor fluctuations in incoming economic data.

Mr Bernanke is certainly right that domestic fundamentals have changed, but I think his blog has underplayed another significant reason for the Fed’s shift, which is a dawning realisation that events in foreign economies are far more important in determining the equilibrium level of US rates than has previously been accepted. In fact, this has probably been the main factor in the Fed’s U-turn this year. Until this changes, the Fed will err on the dovish side whenever a key decision is taken.

…What has caused the sudden drop in the Fed’s estimate of r* since mid 2015, and particularly in the first half of this year? Interestingly, this has not occurred because the Fed has been surprised by the behaviour of the economy since then. The FOMC’s median forecasts for both GDP growth and core inflation have barely changed over this period.

…If we look closely at the timing of the change in the Fed’s guidance about “normalisation” of rates, it came predominantly around the time that the dollar peaked (and equities collapsed) in February/March this year. This did not lead to any change in the Fed’s estimates of either GDP growth or inflation, but it did lead to a change in their expected mix between the exchange rate and domestic interest rates in delivering the tightening in financial conditions that they desired at the time. A higher dollar essentially forced them to accept lower interest rates in order to deliver roughly the same path for overall financial conditions in the economy.

…The best analysis of this issue from inside the Fed has come from Lael Brainard, a relatively new member of the Board of Governors with a particularly strong international orientation in her thinking. To her credit, she pointed to all of these international factors before the FOMC raised rates last December (though she then went along with the change).

In her latest speech in June, she again emphasised the importance of global deflation risks, especially in China. These risks will lead to a very long period of aggressively easy monetary policy outside the US, which in turn will make the dollar far more sensitive to US rate hikes than has been the case in some earlier periods. The Fed should not, she argues, ignore this when setting US rates: the equilibrium interest rate in America has been reduced by events overseas.

Quite right. Markets have been well ahead of the Fed on this but earlier this year it was clear that it was actually growing distress in global high yield debt markets that derailed Fed tightening, notwithstanding the US’s direct exposure to those markets via its shale oil sector.

Some analysts have theorised that to make matters easier for the Fed that a deal of sorts was done at the concomitant G20 meeting, an analogue of the Plaza Accord, that would enable the US dollar to weaken in part by other central banks backing away from their easing projects. The hawkish behaviour of Japan’s central bank especially since then supports the notion.

Whether or not it was just a dovish Fed or a deal was done at the G20, Credit Agricole notes that the relationship between US rates and dollar has broken somewhat of late:

As we highlight in Figure 2, the correlation between US financial conditions and the dollar broke down around May 2016, with the USD starting to recover while financial conditions continued to ease driven by stronger equities and tighter credit spreads. Thus, outside of the volatility around the UK’s EU referendum, broader markets have tolerated renewed USD strength rather well. One could point out that this resilience in risk sentiment is due to very low US front-end yields. However, real US yields have been climbing recently without triggering a reversal in the equity market uptrend.

It would be premature to conclude that the negative feedback loop from the USD to Fed policy has been broken since sentiment is yet to be tested by any meaningful increase in Fed tightening expectations. However, it is clear that the link between a stronger USD and tighter financial conditions has weakened recently. Ultimately, we suspect the Fed will be sensitive to the broader financial conditions rather than the USD per se. This means that some moderate Fed tightening (we see one hike by the end of the year) would not be inconsistent with moderate USD appreciation, in line with our current forecasts.

Perhaps, but the timing will be critical on one other front. The weakening of the correlation between US tightening and its dollar has in part been driven by two other factors. The first is Chinese stimulus and improving growth to the extent that that has exaggerated market hopes for a self-supporting emerging market rebound despite Fed tightening. The second is the degree to which the oil market has rebalanced, allowing the dollar to rise without crashing crude, associated debt markets and commodity prices more generally.

With China clearly set to slow in H2 and crude in trouble if OPEC blinks again (which is my base case) I see little prospect of the Fed being able to tighten again this year. Perhaps next year if China throws more dough at some new roads to nowhere. However, it’s interests are best served by keeping the Fed on the sidelines meaning there’s no rush.