Lombard: Fed will taper then reverse course

TSLombard with the note:

Focus on the taper is understandable but misplaced–the Fed’simpact on this cycle will come from AIT having ended the strong dollar policy. TheFed has moved from using interest rates as needed to stabilize the dollar and sustain foreign capital inflows, to using the balance sheet to offset foreign financing inflows sufficiently to allow real rates and the dollar to fall. We set summer 2019 as the first tactical use of this policy shift, and adoption of AIT a year later a sformalization of this policy as tactic for all phases of the business cycle. The market can rest assured that taper lasts only until real rates rise because of the Fed’s absence and thus creates a “tax”on the expansion.

The Fed’s reluctance to announce a taper to begin months from now, assuming the economy behaves, is rooted in their 2018 experience when QT sharply tightened financial conditions. They need not be so concerned this time around, at least notfor2022. In 2018 the deficitdoubledjustasQTwent full bore, while in 2022 the deficit will be about $1trn less–about the Fed’s rate of purchase of US Treasurys. However fast the Fed plans to taper their pace, purchases will not be zero in 2022. With the Fed buying less and the Treasury needing less than that, financial conditions will remain easy.

While the Fed will keep from buying too few too fast, the current problem is that they are buying too many. Keep in mind that as the Fed continues to buy $80bn notes and bonds per month, regardless of price, the rapid economic recovery is dropping Treasury financing needs (third quarter needs dropped $148bn from original plans). At the same time the inflow of foreign capital inflows has jumped, the result of the non-oil goods trade deficit skyrocketing as US firms look to meet customer demands and rebuild inventories. All of which adds to a supply/demand imbalance that has lowered nominal yields despite the expansion continuing to make marked inroads in recovering employment and economic activity. The Fed will use the economic argument to begin tapering (expect the official announcement in September, the unofficial one was made in July, reiterated in Monday’s WSJ article, and likely underscored further with the release of the minutes of the July FOMC meeting on Wednesday), when the point really is that the Fed promised not to tighten too soon–they never promised to ease further as the economic rebound took hold.

One possible delay to the start of taper will be the debt ceiling. The Democrats intend to raise the debt ceiling with Republican votes, and most estimate that Treasury runs out of money in October/November. By not using the reconciliation process that is available to them, 60 votes are necessary, and this means compromise with Republicans–who are uninterested in compromising. Debt ceiling votes are partisan by design. Remember that in the wake of the Republican tax cuts in 2018, the Republicans suspended the debt ceiling for a year and then suspended it again in 2019 until July 2021, bringing the problem today, on time for a Democrat in the WhiteHouse (want to guess whether this vote would be a issue if Trump was re-elected–in2017 Trump suggested getting rid of the vote altogether). The Republican’s mid-termmessageaccusesDemocrats of an expansive fiscal policy that is inflationary–working with the Democrats on the debt limit undermines the message. Both sides eventually compromise when market pressure becomes extreme. In the meantime, the TGA is below $400bn ($1.6trn when the year began) and likely headed to around $40bn, its bottom in 2017 before that year’s vote to raise the ceiling (bipartisan). The debt ceiling will be theatre with the ending known in advance, but the game has been known to add volatility to markets–the Fed will want the issue cleared before starting to taper and that flips the calendar to early 2022.

The cost of the strong dollar policy was a hollowing out of the tradable goods sector of the economy and downward pressure on US wages. A persistent trade deficit with a frozen currency pushes a downward domestic adjustment on the trade deficit nation. The benefit of the policy is lower US inflation and strong global growth. The US began to move from its dollar policy with QE2, with some domestic success, but the ECB eventually countered in 2015 (following Japan and China) and the result was a sharply higher dollar and a bigger goods deficit. Unlike 1971, the world enjoys a strong dollar fostering a wider US trade deficit now that the dollar is also the global currency of finance. The Fed compounded the problem of a too strong dollar in 2017/18 by chasing a mythical inflation problem (there is none when a strong dollar supported by high real interest rates combines with a growing trade deficit) by raising policy rates well above those of competing currencies (yen and euro). AIT is a promise not to do this again.

In 1971, Nixon faced a similar issue when domestic inflation was creating an increasingly mispriced currency due to fixing and the trade deficit was widening as a result. Unlike today, the global overhang of dollars was not embraced, and with too little gold to meet convertibility demands, Nixon shut the gold window. Bretton Woods had to collapse soon after and the subsequent 20% drop in the dollar versus the yen and the deutsch mark was a revenue shock to global commodity producers that was answered with sharp price increases all around–not just for oil. The rest, as they say, is history.

The tie to today? If, and it is a big if, the Fed holds to its promise of lagging on increasing the funds rate, the persistent US trade deficit will be met with a weaker dollar. The financing problem the Fed was concerned with in the 1990s is no longer because the Fed is committed to owning Treasury debt to keep rates from rising inordinately. The knock-on effect is the end of 25 years of zero inflation in consumer goods prices ex food and energy, a lift to the US tradeable goods sector and the end of sustained downward pressure on wages in these industries. At the same time, global commodity producers will be induced to raise prices–not like the 1970s, but higher nevertheless. On the other hand, a smaller US trade deficit is a drag on a global economy unless offset by a bigger Chinese trade deficit. The reduction of US dollars being exported could become problematic, although the Fed has its swap lines open just in case.

In sum, there are many reasons why the coming expansion will be different, and one is the end of a strong dollar tactic by the Fed, and likely supported by the Administration (where the dollar decision is made–Treasury to be exact) because it works with re-shoring efforts. These issues and their potential are where eyes should be focused. Taper does not matter until it does matter,and if it matters too much, the Fed will be back buying.

This is well and good but what happens if China and Europe are weaker than the US and refuse to run current account deficits even as they ease monetary policy in response?

The problem of the strong dollar is not of the Fed’s making. It is Chinese and European mercantilism that is to blame.

Still, I agree that the Fed will be forced to untaper, if it goes ahead at all, and when it does we’ll see a big relief rally in the usual risk assets.

Yet, before very long, even that won’t be enough for commodity prices if China refuses to spend like it used to, continues with reform, and slashes its interest rates instead.

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