The third quarter begins with clarified monetary policy outlooks for the US, EMU, and Japan. At the end of Q2, the Federal Reserve signaled it would likely raise rates in September and December. The unwinding of the balance sheet, though, continues at a rapid pace. In Q3, the Fed will not reinvest the proceeds of the $40 bln of maturing bonds a month, reaching a terminal velocity of $50 bln a month in Q4.
The ECB will continue to buy $30 bln euros a month of mostly sovereign bonds through Q3. It will slow the purchases to $15 bln a month in Q4. It does not anticipate a rate hike for at least another year. The Bank of Japan is slowly reducing the amount of bonds it is buying, but no one is confusing it with tapering. It successfully managed to keep Japanese yields largely immune to the rise and volatility in yields abroad.
A common narrative was that the dollar’s decline last year marked the end of divergence, but it still has legs and will for a few more quarters. The US interest rate premium over the other high-income countries is either at record highs or multi-year highs. The US mix of tighter monetary policy and looser fiscal policy is as close to a currency elixir as could exist. It helped fuel the Reagan-Volcker dollar rally of the early 1980s. It was the policy mix in Germany after the Berlin Wall fell, which led to the Deutschemark overshoot that wrecked the Exchange Rate Mechanism, the Maastricht Treaty, and monetary union.
The US policy mix is extreme. The US has been gradually increasing interest rates since December 2015. Neither the ECB nor the BOJ has been able to raise interest rates even once. While the current monetary setting is still understood as accommodative, the Federal Reserve anticipates that policy will become restrictive by the end of next year. The fiscal stimulus that is hitting the US economy is as large as that from when the US was in the throes of the worst financial crisis since the Great Depression.Add in the particular details about the tax cuts that encourage companies to repatriate assets and the basis for the US sucking in the world’s capital is laid.
Global savings are coming to the US, and this displaces other borrowers. Among the first to feel the pinch are developing countries with large current account deficits and other challenges that could be overlooked amid the deluge of liquidity. The rising US yields also dampen the attractiveness of traditional high-yielding Australian and New Zealand dollars. Even Canada, which has hiked rates three times since the middle of last year, and is likely to hikes rates again in Q3, is no match. The US dollar rose to its best level in a year against the Canadian dollar at the end of Q2.
Economic disappointment in Europe and Japan make the US policy mix all the more potent. The eurozone economy slowed in Q1, and although some transitory factors were at work, growth does not appear to have picked up in Q2.In May, a little more than a third of eurozone government bonds, or 7.3 trillion euros, offered the still-confounding negative interest rates. The best days of the broadest economic expansion could well be past. The ECB staff forecasts slower growth in the next two years. The Japanese economy narrowly contracted in Q1 and appears to have been expanded a little in Q2. The Japanese yield curve is negative out eight years at the end of Q2 18. The Japanese government debt-to-GDP is among the most in the world, yet the US offers nearly 100 basis points more to borrow for four weeks than Japan offers to borrow for 40 years.
II
The consequences of the US policy mix in the context of developments in Japan and Europe may be the most disruptive force that investors will have to navigate in Q3. The main rival for this dubious honor belongs to trade. There are some US academics and policymakers who believe that if exchange rates are freely floating and trade is free, there should not be sustained deficits and surpluses. And since the US runs a chronic trade deficit, it follows as night does day that someone is circumventing the rules.The difference is that people who share those views have the reins of power.
