In the Fed’s March policy statement this week, a funny thing happened on the way towards acknowledging the stronger US economic data of late – they largely ignored it and buried notice beneath a blanket concern for the ailing health of the global economy. By doing so, they broke the back of the US dollar, which had already begun unwinding the overshoot – that to a great degree had been motivated by the Fed’s own projections over the past two years of a tightening cycle more comparable to previous contemporary rate hike regimes, than the realities of normalizing policy from ZIRP. When the dust settled on the statement, the Fed had walked back their scope for raising interest rates through the end of this year from one percentage point to only half a percentage point and lessened the trajectory of prospective future rate hikes through 2019 to 3.25 percent from 3.50 percent.
Why they chose the March meeting to shift expectations is an open question – as well as the follow-up of whether the Fed’s “hike-hype” was always a strategy to begin with. As we’ve noted over the years, in the trough of the long-term yield cycle where a fraction of a percentage point is likely the best the Fed can reach for, policy is administered through posture as much as action. While it was more discrete than conventional policy expectations, a strong dollar – disinflation and rising real yields largely accomplished the heavy lifting of tightening for the Fed this time around.
That said – and regardless of their intended approach or lack thereof, a signal has now been cast, which as participants have felt carries real impact in the currency markets and within the broader macro environment that the markets trade against. At the beginning of February we summed up the Fed’s predicament with the dollar with the now foreshadowed conclusion that the currency would ultimately break down when the Fed called its own bluff:
The fact remains that despite hiking the fed funds rate a quarter percentage point in December, financial conditions have actually loosened as nominal yields have fallen but inflation expectations have firmed. This is the opposite dynamic of the taper tantrum in 2013 where real yields spiked as inflation softened and nominal yields rose sharply. Over the past several months we’ve speculated that just as the Fed’s tightening regime was as discrete and unorthodox with conventional wisdom, the dynamics in which easing might be accomplished today could be just as atypical. As noted above, a strong dollar – disinflation and rising real yields largely accomplished the heavy lifting of tightening for the Fed and a weaker US dollar could broadly reverse those same effects both domestically and abroad. It remains our opinion that should the dollar continue to weaken it would create the smoothest transition during another esoteric period of policy normalization, as the Fed would certainly hold serious reluctance to quickly unwinding its move off ZIRP or entertain a far more uncertain and hence less effective approach such as negative rates.
As we mentioned in a note last month (see Here), the Federal Reserve Bank of San Francisco recently published an Economic Letter that argued by allowing inflation to overshoot the Fed’s 2 percent target, it would achieve the greatest decline in real yields and hence stabilize economic activity fastest (see Here). We would argue that what the Fed effectively did this week by discounting the firming US economic data and deferring to a general concern for the health of the global economy is shift their reaction function to a willingness to remain behind the curve on inflation. Hyperbole aside – it's a rather big deal.
And while markets have already been reflecting this shift in inflation expectations for several months as gold has predictably led the broader reflationary trend – to see the Fed bless this perspective should reinforce investors convictions that market conditions are shifting favorably towards supporting assets like precious metals, commodities and emerging markets that were left for dead as financial conditions tightened and real rates rose over the past several years.
As shown below, although the Fed pulled back their rate hike projections this week – from a historical perspective of the long-term yield cycle, they likely still have a ways to go towards aligning expectations with reality. Moreover, while nominal yields may firm over the coming months, the prospects for the dollar from a policy or intermarket point-of-view look quite clear: lower for longer as well.
As we highlighted a few weeks back, gold had led the broader commodity complex higher – with industrial metals, oil and agricultural prices now catching up with gold's leading breakout move. All things considered, the near-term prospects for gold remains less compelling here, as we suspect the retracement move lower will continue.
Regardless of the Fed's apparent shift, this perspective continues to look compelling considering the bullish long-term set-up in the silver:gold ratio.