For at least half a decade now, Federal Reserve skeptics have leveled one complaint against the central bank above all others: that the Fed is “behind the curve.”
The cynics are concerned that the Fed is too focused on fighting the last war rather than emphasizing normalizing monetary policy and that central bankers have become too complacent and will allow inflation to surge. After the unprecedented size and scope of the Fed’s response to the Great Recession, including three iterations of quantitative easing that drove the central bank’s balance sheet to $4.5 trillion in assets (to say nothing of the similarly dramatic fiscal policy response initiated by Congress), this is certainly a legitimate concern.
However, the Fed’s response to the recent U.S. economic data actually suggests that the opposite risk, that the Fed is actually too far ahead of the curve, may be the more salient one for investors.
The Fed raised interest rates a quarter percent in June, bringing the central bank’s target range for the Fed Funds rate to 1.00% to 1.25%. This marked the fourth interest rate hike in 18 months, and if policymakers have their way, we’ll see one more quarter-point increase by the end of the year.
Interest rate hikes are not the only way that the Fed is seeking to normalize policy. Last fall, the central bank floated the idea of shrinking its balance sheet, with the implication that any such move would be years in the future. Earlier this year, the Fed suggested that the process could begin at some point in 2018. At the most recent meeting, Fed Chair Janet Yellen described the plan for the balance sheet in full detail and stated that the process would begin “relatively soon,” which traders have taken to mean in September or October.
Critically, all of this hawkish talk has taken place against a worsening domestic economic backdrop. In the month of June, economic reports on nonfarm payrolls, retail sales, durable goods, inflation numbers and a host of others all came in worse than in May, with most of those readings coming in below economists’ expectations. In other words, there is widespread evidence that U.S. economic growth unexpectedly slowed through May and into June.
The Fed, which prides itself on being “data dependent,” has thus far opted to look through what it sees as a temporary downshift in the economy. But what if the slowdown in economic activity isn’t transitory?
In that case, Yellen and company will have to choose between two unsavory options. Either the Fed will stick to its guns, risking a recession by tightening into a slowing economy, or the central bank will be forced to change course and adopt a more neutral outlook.
When it comes to the forex market, the most important factor driving currency values is not the absolute stance of central banks, but rather the changes in monetary policy relative to the market’s expectations. Just as traders are finally accepting the narrative of the Fed being the only hawkish central bank in town, the tide is shifting once again.
At the end of June, forex traders saw a big shift in outlook across numerous central banks. In one week alone, the heads of the European Central Bank, the Bank of England and the Bank of Canada all made comments about removing some of the emergency monetary measures announced during the last few years. In other words, other G10 central banks are preparing the market for tighter monetary policy at the exact time that the U.S. recovery looks increasingly fragile.
While the June jobs number was better than expected, if the rest of U.S. economic data fails to improve markedly over the next couple of months, the greenback could be vulnerable, particularly against its northern neighbor (see “Year of the loon?” above). After a multi-year downtrend, speculators have accumulated heavy net short positions in both the Canadian dollar and crude oil. With the Bank of Canada shifting to a more hawkish outlook and the U.S. dollar/Canadian dollar (USD/CAD) currency pair breaking below its one-year channel, North America’s forex balance of power may shift in favor of the loonie through the second half of the year and beyond.