See the latest Australian dollar analysis here:
TS Lombard with the note:
Powell reiterates AIT policy.In the end, the Jackson Hole policy retreat did not herald the announcement of a major policy shift (we never thought it would, but some investors were betting on a hawkish surprise.) Markets interpreted Fed Chair Powell’s speech as dovish, buying equities and selling USD. Indeed, Powell gave investors two important messages: first, that there is no linkage between the taper and rate hikes and the latter will not necessarily start as soon as the former comes to an end; and second, the bar for rate hikes is much higher than the bar for a taper, including the need to achieve maximum employment.AIT (average inflation targeting) is still the Fed’s explicit policy stance, meaning the policy rate will be more accommodative than it would otherwise have been at any given point in the cycle. Today we draw two key points from this stance: the dollar smirk and the transition risk to hawkish policy.
The dollar smirk is a structural headwind to USD. We first introduced the idea of the dollar smirk this time last year, highlighting how the Fed’s new policy stance marks the end of an era of strong dollar policy. Indeed, the central bank’s policy stance is now explicitly dollar-negative: all other things being equal, the policy rate will be lower than otherwise expected at a given point in the
cycle. Our US economist highlights why such a policy is a key pillar of support for the next leg of economic growth as it is focused on re-shoring production and reducing reliance on cheap imports from overseas.
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But dollar performance is not de-linked from external dynamics. The Fed weaker-dollar stance certainly helps to change the behaviour of USD but it does not mean a one-way-street. The dollar will still behave in a similar way to how it has behaved in the past: rising on risk-aversion, falling on global risk-appetite improving and, not least, rising when the US growth outlook improves compared with that of the rest of the world.
Over the past few weeks there have been good reasons to own USD, in particularChina’ssimultaneous crackdown on overt capitalism and zero-tolerance policy on Covid leading to a soft patch in growth. However, we expect the magnitude and sustainability of these gains to be less than pre-AIT, giving opportunities to tactically sell USD on rallies. We have held USD shorts over the past year against KRW, GBP and NZD; at the moment we hold a small USD long against AUD and NZD–a classic example of external dynamics (zero-Covid lockdowns in the antipodes) affecting USD.
For now, the market’s interpretation of Fed policy is dovish. Money markets discount roughly two Fed hikes by the end of 2023(according to fed funds futures). This is broadly in line with the central bank’s forecasts, where the median “dot” indicates two hikes over the same period. So far, so dollar-bearish. But we are here to warn about risks on the horizon as well; and reading between the lines of Powell’s speech, we can see the risks building.
On the face of it, Powell’s speech was a clear dovish signal on rates. But the message is more nuanced–and less dovish–than it first appears. When we discussed AIT policy this time last year, we highlighted how the turn from dovish to hawkish policy may be characterized by high volatility. This transition is certainly not around the corner, but it is still likely to be fraught: thinking about the risks and consequences of the transition should be on your radar.
The execution of AIT policy may be less dovish than previously anticipated. In his speech, Powell betrayed concern about high inflation: the apparent acceleration of the planned taper pace reflects the Fed’s preference to extract itself from the market sooner rather than later. And Vice-Chair Clarida, in a speech earlier this month, calculated the inflation “average” from August 2020, the date of adoption of this new framework; based on this definition, Clarida expects PCE inflation to average 2.5% through year end 2023 (the dark green line in Chart 4). When the framework was introduced, the details of the average period were never specified; but a mere three-year average–which is likely to be dominated by transitory reopening effects–is a surprisingly hawkish interpretation of the policy. As Chart 4 shows, any other interpretation–a longer average period or an assumption that some of 2021 inflation is transitory–would reflect a more dovish policy stance. The risk is that the Fed does not look through 2021 when it calculates average inflation next year, thereby turning more hawkish than it promised to under the AIT framework.
Policy rate probability distribution has a fat right-hand tail.Chart3 aboveplotstheMinneapolisFedinflation skew probabilities, derived from market prices (swaption caps and floors). There is, in effect,zero chance of CPI running lower than 1%over the next five years and a35% chance of itrunning higher than3%. Theoretically, this is proof of the success of AIT policy. But as we note above, there are hawkish nuances in current communication. And more uncertainty about the outcome of inflation (which a high >3% inflation probability implies) means the term premium–which, in effect, is a measure of uncertainty in the Fed’s rate hike path–should be higher.
The risk with the Fed’s new policy is that it becomes hostage to fortune. Or, more colourfully: the Fed has a plan until it gets punched in the face. The risk to current policy is that it turns more hawkish earlier than expected either because the central bank neglects to look-through transitory inflationas a result of acting early to avoid the fear of an inflation expectations spiral or (the best case) there are genuine domestically driven inflation pressures due to the economy reaching maximum employment earlier than expected. We do not expect this risk to play out this year; but as the taper comes to an end in Q3 or Q4 next year and the Fed’s supportive impact on asset prices diminishes, the risk of a regime switch from dovish to hawkish policy will be on the table.
The Fed is following a dovish average inflation target monetary policy–until it isn’t. For now, the right approach is to play the ball where it is now: the Fedremainsultra-dovish, yields remain compressed, asset prices remain supported and the dollar remains offered. But we need to watch where the ball is going: when the Fed begins to worry about inflation, policy could tighten quickly at a time when there is no central bank bid for assets