Bank to the Future: Interest rates return to market center stage

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Interest rates have been this year’s focus for currency valuation. American Treasury yields have climbed sharply fueling the dollar’s rise. The Federal Reserve has two discrete rate policies, a repressive bond program for the short-term and a laissez-faire acceptance for the medium and long-term. Both are dependent on the US economy’s rapid growth.  Can the US and the American consumer pull the world to recovery? Join senior analysts Valeria Bednarik, Yohay Elam, and Joseph Trevisani for the examination.

Joseph Trevisani: US data for March has been very good, payrolls almost one million and 1.6 million for the quarter, manufacturing PMI was the best in 38 years, services in the series history-24 years, and consumer confidence pulled up sharply, but can the US consumer cover for the world?

Yohay Elam: It is the world’s No. 1 economy.

Joseph Trevisani: Yes, but it is running massive deficits, which markets are ignoring.

Valeria Bednarik: That’s old history. I mean, nobody ever cared about US massive deficits.

Joseph Trevisani: And we have a little buy the rumor and sell the fact in the currency and credit markets.

Valeria Bednarik: Not even the US government.

Joseph Trevisani: Yes it is old history, but also apparently future history.

Valeria Bednarik: Yups, also. Like massive stimulus, is here to stay.

Yohay Elam: The lack of massive deficits is dragging Europe down, again. When interest rates are low, it is time to invest. That is what the US is doing.

Joseph Trevisani: True, but does massive debt diminish private investment? Japan is the example where the BOJ is both the largest holder (and issuer) of debt and the largest single investor in equities. The Japanese economy over the past two decades has performed woefully.

Yohay Elam: Japan is a good example of how debt doesn´t matter. US and Japanese demographics are totally different.

Joseph Trevisani: Yes cheap debt encourages investment, but when it is government debt it also encourages permanent low rates. Japan has grown very slowly for 20 years, it would seem that endless government debt, endless stimulus, and permanent low rates are pointless. They certainly do not produce growth.

Yohay Elam: So, you are in favor of tax hikes?

Joseph Trevisani: Hahaha not usually, lower spending is my preference, though in the current case the stimulus programs so far, even if wasteful and for the last little focused on actual consumer support, where needed, if for psychology alone.  I have doubts that the current supposed infrastructure plan will accomplish much except raise the debt.

Yohay Elam: Trump’s tax cuts did not change the growth trajectory, so raising taxes would not weigh on growth and help lower government debt. It is early to know if infrastructure spending would help, but PMIs at record highs show some kind of approval to these plans from businesses.

Joseph Trevisani: Possibly, PMIs could also show confidence from the near-record inflow of orders. I think that government spending plans have far less impact on GDP than assumed. Infrastructure spending is impossible to accomplish in any rapid fashion. the Obama administration discovered that with their ‘shovel ready’ projects. There were very few. Still, some sort of huge program will get through  Congress, so I think markets have already assumed its reality.

Yohay Elam: EUR/USD is off the lows. I think that reflects optimism that rapid US growth will eventually lift all boats. Or perhaps that Europe will catch up with vaccines?

Valeria Bednarik: The EU can’t catch up with vaccines. There’s no time. I would say that the US advantage is clearer as time goes by and the market is trying to reflect it.

Joseph Trevisani: I think both.  Europe will eventually catch up with vaccination though the failure, especially when compared to the US and Israel, will damage the popular view of the EU.  The timing could not be worse. The UK leaves and runs an excellent vaccination program. I am more optimistic about Europe.  Perhaps the national governments will take over the vaccination access and distribution. But I agree, markets are reflecting the disparate reality in the US, the UK, and the EU.

Yohay Elam: I think that one of the euro boosters this week came from the projection that the majority of populations will get the vaccine by the end of June. The pound has been reversing its gains. I think that it is due to vaccine delays in April and profit-taking.

Joseph Trevisani: And the US yield rise has stalled.

Valeria Bednarik: Those models… there are multiple ones suggesting herd immunity for the UK by April/May, but Hancock dismissed them. Something everyone is forgetting is that no country is an island, well, except Australia and New Zealand. What I mean is that we are in a globalized world. Herd immunity in one country is meaningless. Of course, it will mean a sooner economic recovery for those countries that achieve it. But is far from being the ultimate solution.

Yohay Elam: It will take time to reach a significant portion of the global population

Valeria Bednarik: Hence, it will take time for economies to fully recover. Some will have a clear advantage once the pandemic recedes

Joseph Trevisani: That is true but at some point immunity, whether natural or vaccination, is widespread enough, so that, except as an individual malady, Covid is no longer a social or economic issue.

Valeria Bednarik: So far, the US and the UK are holding such an advantage.

Yohay Elam: Indeed, but the US and the UK need others to trade with.

Joseph Trevisani: Exactly, It seems the countries that were most successful in vaccination, will reap the economic benefit.

Valeria Bednarik: Exactly.

Joseph Trevisani: Currencies are a modest expression of that.

Valeria Bednarik: That’s why I say I advantage indeed, currencies are being shy to reflect this.

Joseph Trevisani: True, the dollar’s rise has been, shall we say, minor? Perhaps some of the speculative energy has been drawn to the crypto world.

Yohay Elam: One explanation of the dollar’s recent softness is that the next US spending will be funded via tax hikes. That implies less debt issuance, thus more expensive bonds, and thus lower yields.

Valeria Bednarik: Could be. How about inflation? can we see spending boosting it at least a bit? enough to spur some speculation of a sooner-to-come rate hike? tapering?

Joseph Trevisani: Well, if I know anything about US  politics, we will end up with smaller tax hikes and higher spending.

Yohay Elam: Metals are on the rise, which may reach the prices of consumer products, but it will take time.

Joseph Trevisani: The Fed has refused to speculate about reducing or ending the bond program. Yet that is the logical and inescapable end.  Will the Fed want to buy $120 billion a month with the economy growing 6%+, I doubt it. Inflation is the uncertainty here.

Valeria Bednarik: Everything seems to be “taking time.” Too much. Maybe the little reaction in markets is part of this pandemic fatigue that has all tired of waiting.

Joseph Trevisani: True, the lingering of the pandemic is trying for all.

Yohay Elam: The Fed is also tired of acting according to forecasts. It is now eyeing outcomes, not outlooks. An “I’ll believe it when I see it” approach.

Joseph Trevisani: Are we back to data dependency?

Valeria Bednarik: Good for the Fed.

Joseph Trevisani: Janet Yellen is at Treasury pushing for a global corporate tax minimum. A windmill for tilting if ever there was one. I agree. Facts are good things for central bank focus.

Yohay Elam: Being behind the curve is the way to go now, not ahead of it.

Valeria Bednarik: The market likes the opposite.

Joseph Trevisani: True, but I think the Fed rate strategy is two-pronged. First, keep rates low and refuse to entertain speculation about ending the bond program. Second, let the market raise rates, and largely ignore the increases.

Yohay Elam: Stock markets have become comfortable with higher long-term borrowing costs. The S&P 500 is at new highs. Will shares continue higher?

Valeria Bednarik: Yes. Stocks are for sure ahead of the curve.

Joseph Trevisani: I think so, at least for a good part of the year.  So far the GDP estimates are only that and given the turmoil of the last year, markets want proof.

Yohay Elam: Recent US economic data has been robust. I would say, so far, so good.

Joseph Trevisani: Retail Sales for March will, if strong, cement the view. So far the projection is 4.4%. If January is the model, it could double the forecast.  The new Orders PMI would seem to support that idea.

Yohay Elam: Will the dollar respond positively to strong US data? Or will it be a risk-on move, sending the dollar down?

Joseph Trevisani: If the US data is accompanied by rising US yields, the dollar rises. if not, it stagnates then falls.

Yohay Elam: Follow yields is the way to go.

Joseph Trevisani: Which is a very traditional currency ploy. It’s from my youth on a trading desk. In the last century. Never buck the Fed, is the old adage.

Valeria Bednarik: So, we should keep an eye on charts and the other on yields. The dollar has responded nicely to the 10-y note yield crossing 1.70% one way or the other.

Yohay Elam: Indeed, 1.70% seems a critical level.

Joseph Trevisani: Yes Val is right.  Take USD/CAD which has resisted the dollar’s advance. One reason is that Canadian sovereign rates have largely kept pace with the US. The USD/JPY is the opposite.

Valeria Bednarik: Exactly.