Currency exchange rates have been the subject of much chatter. In spite of the consensus belief that the USD would remain strong, if not move to parity with the euro currency, the USD has weakened during the first half of the year. The reason for the decline of the dollar? Low U.S. inflation and resulting low UST yields, as well as an increase of inflation in Europe and a corresponding rise of EMU sovereign debt yields. The resulting drop of the U.S. dollar has market participants and strategists warning about rising U.S. inflation.
There is good reason to be on the lookout for a mild pickup in U.S. inflation. A USD at or near current levels (around 1.16 versus the EUR and 94.20 on the DXY Index) should juice inflation via higher import and/or commodities prices. However, we must manage our expectations. I doubt a USD at around 94.2 on the DXY Index will push the Fed’s favored measure of inflation (Core PCE YoY, which last printed at 1.4%) to the Fed’s 2.0% target. Maybe a USD at or near current levels can add 20 or so basis points to Core PCE. That is my opinion, anyway. The TIPS market is not pricing in a surge of inflation.
At the time of this writing, the 10-year U.S. TIPS breakeven stood at 180 basis points. This means that market participants are pricing in average annual headline CPI (often the highest reading of U.S. inflation) at 1.80% over the next decade. The bond market does not see inflation as a problem. The bond market also appears to be opining that fiscal policy reforms and tax cuts are likely to be fairly moderate, if not modest.
Although there is much chatter regarding how a weaker USD can boost U.S. inflation pressures, there is surprisingly little chatter regarding how a stronger EUR could lessen EMU inflation pressures. Although I have mentioned this several times, during the past several weeks, I have been a rare voice crying in the wilderness. In fact, I have been crying for many months. In the Bond Squad’s Q1 2017 Review, publish last March, I stated:
The bottom line is; unless there is upward pressure of inflation both in the U.S. and overseas, long-term interest rates could be well contained. That would require rising inflation both here and abroad. The problem is that the majority of inflation pressures in the EMU have been due to a weaker euro currency. There are signs that the inflationary effects from a weaker currency are fading.
Picking off European inflation
The March reading of annual German CPI printed at 1.6%. This was down from a prior 2.2% and below the Street consensus of 1.8%. Some pundits tried to blame the timing of Easter in 2017 versus 2016, but it appears that the softening year-over-year energy comps are alleviating EMU inflation pressures. This reading of German inflation does not factor in the recent strength exhibited by the EUR. A stronger currency is also anti-inflationary.
I (Bond Squad) was discussing this fourth months ago! Since then, German CPI has been stuck between 1.5% and 1.6%, in spite of strong economic data. Just as the weaker USD has inflationary potential for the U.S. economy, stronger EUR has disinflation potential for the EMU economy. In spite of all the hawkish anticipation surrounding ECB policy, ECB president, Mario Draghi, knows he cannot permit the EUR to strengthen precipitously, at least not without a fight. If he allows the EUR to continue its upward trajectory, he risks undoing the progress made in the areas of EMU inflation and GDP. A stronger EUR could also harm German exports. That could slam the brakes on the EMU economic rebound.
Remember, currency depreciation is a kind of monetary easing as it is pro-inflationary and pro-exports. Thus, it tends to be pro-growth. In spite of the denial of some central bankers, currency devaluation is a prime goal of monetary policy accommodation. A weakening of a currency is pro-inflationary and provides a central bank with room to remove monetary policy stimulus. Thus, the weakening if the USD could encourage the Fed to continue tightening monetary policy.
Interest rate/dollar tool
I am not alone in thinking that the weaker USD has eased financial conditions. Morgan Stanley Chief U.S. economist, Ellen Zentner, believes that the weakening of the U.S. dollar has offset about 75 basis points of the Fed’s 100 basis points of Fed Funds Rate hikes.
This sounds logical to me, but if the falling USD has had the effect of easing financial conditions in the U.S., wouldn’t the rising EUR have the effect of tightening financial conditions, in Europe? Why are so few strategists discussing the potential anti-growth and anti-inflation impacts from a stronger euro currency? It can’t be that they don’t understand the situation.
My guess is that they have talked-up the European recovery story and have encouraged greater asset allocations to European assets, thus they are reluctant to tell clients that the European recovery may have hit a speed bump. The strategists at Morgan Stanley also share my view that the U.S. dollar could be range-bound versus the euro currency. It appears that the USD has hit a wall at just above 1.16 versus the EUR, at least for now.
About Thomas Byrne
Thomas Byrne has achieved a 26-year career in financial services, 23 of which have been spent in the fixed income market sector. In his role as Director of Fixed Income for Wealth Strategies & Management LLC., Byrne is responsible for providing strategic analysis and portfolio management to private clients and institutions, in addition to offering strategic advisory services to other financial services organizations. Byrne's areas of expertise include trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt, and convertible bonds. Additionally, Byrne provides analysis, strategy, and commentary within the fixed income market. Prior to joining WS&M, Byrne worked as Director in the Taxable Fixed Income Department of Citigroup, Inc., in addition to predecessor companies in New York, NY.