"Kee" Points with Jim Kee, Ph.D.


  • Yield Curve Again?
  • Trump and the Fed
  • Three Forces and The Dollar
  • Dollar and Currency Wars
  • That Goes for Oil Too

  

Yield Curve Again?

I know I have talked a lot about the yield curve in Kee Points lately, so I know the topic is getting tiring. However, I did want to share with you a few insights from a recent Credit Suisse report titled, “U.S. Equity Strategy: Yield Curve Inversion Won’t Signal Doom.” Over the past 50 years in which inverted yield curves have preceded recessions, the lead time has been very inconsistent, with recessions following anywhere from 14 months later to 34 months later. Equities (stocks) rose an average of 15%-16% in the 18-month period following an inverted yield curve, with a range of between -11% and +30% (Credit Suisse). The note asserted that historical flattenings have anticipated slowing growth, while today’s flattenings are due to divergent global economics as longer-term treasury yields are “tethered” to other sovereign (government) bonds, while short rates reflect stronger U.S. growth (and concomitant Fed policy).


Trump and the Fed

Speaking of Fed policy, I am sure you saw in the press that President Trump was “not thrilled” about the Fed’s recent rate hikes and its stated intentions to continue with more hikes going forward. The President feels that the Fed’s actions could derail the nascent economic recovery, and his comments caused a small media frenzy over whether or not he was threatening central bank independence. To be honest I think the media was just trying to spice up a non-event. But as an economist I can tell you that central bank independence is important! Most economic textbooks display the relationship between central bank independence and economic growth across different countries and time periods. Without a doubt, countries with central banks that operate independently of whichever political group happens to be in power at the time grow much faster (i.e. enjoy more opulence) than those who’s central banks are controlled by the current ruling party. Central bank independence is measured by things like price stability (particularly in developed countries) and central bank leadership turnover (particularly in developing countries). Perhaps no central bank is truly or purely independent, but a high degree of independence is definitely preferable to a low degree of independence.


Three Forces and The Dollar

The value of the dollar relative to other currencies (i.e. exchange rates) is driven by (at least) three somewhat independent forces today. The first force is a “safe haven” effect, as global money flows into dollars and drives up the dollar’s value whenever there is some large global concern. The second force is differential central bank policies, as the central bank of the United States (the Federal Reserve) is moving rates higher and has ended asset purchases, while central banks in the rest of the world (Europe, Japan, China) are still targeting low rates. This makes income-yielding investments in the US more attractive than those in other parts of the world, and investors bid up the price of dollars to purchase them. Finally, differential growth rates between countries (even if central bank policies were identical) tend to lead to differential rates-of-return. When growth is higher in the US than in the rest of the developedworld at least, it can lead to capital inflow and a demand for dollars.


Unfortunately, many analysts focus on just one of these three forces, which leads to confusion or partial understanding. For example, you often hear analysts say, “strong economy, strong dollar.” That reflects the last force, or differential growth rates. But in fact, you can have a strong economy and a weaker dollar, if the economies in the rest of the world are growing even faster. It is growth relative to the rest-of-the world that best describes the relationship.


Or you can have a situation like last week, when President Trump attributed the dollar’s strength to the second force, or central bank policy. Trump suggested that the Fed’s actions of raising rates, when the rest of the world’s central banks are not, is making the dollar too strong and hurting US exporters.


Finally, you can have a situation like the global financial crisis in 2007-2009, or the Standard & Poor’s downgrade of US debt in 2011. The dollar spiked (rose) dramatically in those periods, and that was because of the first force, the safe-haven effect. My point is that all of these factors―the safe haven effect, differential central bank policies, and differential growth rates―affect the dollar to varying degrees in different time periods. Don’t fall into the error of always ascribing the dollar’s movements to just one force while ignoring the others.


The Dollar and Currency Wars

China started pegging its currency to the dollar back in 1994, and it acquired instant monetary credibility by doing so. But when you tie your currency to that of another country, and your growth accelerates dramatically relative to that other country, then there is pressure for your currency to appreciate. That was China in the 2000s after it joined the World Trade Organization in 2002. Many in the US at the time charged China with keeping its currency artificially low by not allowing it to float and appreciate relative to the dollar. But others advised China that if it cut its currency’s link to the dollar and let it float, it might just lead to capital flight and a currency collapse, because it was not known whether or not the world was interested in holding a freely floating fiat (not backed by anything) currency from a communist country. China chose to incrementally loosen the band around which it pegged its currency to the dollar, allowing it to appreciate a little while being called a currency manipulator at the same time. Today, with China’s growth slowing, the forces on China’s currency are the reverse, or for it to weaken.China is again loosening the peg a little and allowing the currency to depreciate, and again it is being labeled a currency manipulator. I think these kinds of situations reflect the lack of any real kind of global monetary framework or coordination in the world at present. This was hinted at in a Wall Street Journal editorial on Monday, which is perhaps a topic for another Kee Points.


That Goes for Oil Too

Last week I mentioned devoting a Kee Points to the topic of oil, but this is not that Kee Points! However, I did want to point out that the error mentioned above, of always seeing a market in terms of just one force working upon it while neglecting or being ignorant of other forces, often occurs in oil market discussions. Oil is influenced by global demand, global supply, and by the value of the dollar. The dollar influences oil prices because globally oil is priced in dollars (If the dollar is weak, it takes more of them to buy a barrel of oil, and the price of oil in dollars rises. If the dollar is strong, then it takes fewer dollars to buy a barrel of oil, and the price of oil in dollars falls.) Like the dollar, all of these forces are typically influencing oil to varying degrees depending upon the period, but I am surprised by how often I see some analysts always talk about oil primarily in terms of the dollar, or of global demand, or of global supply conditions. You should always start by recognizing all three.