Known Unknowns And The Dollar

There are three, and arguably interrelated, known unknowns that are seemingly on everyone’s mind.  

First is the decline in global equity markets. Is this simply a long overdue correction? Wasn’t August 24 some sort of capitulation?  Is this a re-test of those extremes, which is not particularly unusual, or is it the start of a new leg down?

Second, is China. In the space of a couple of months, China has gone from the invincible and irrepressible to the gang that couldn’t shoot straight.   The veneer has been ripped over, and the emperor does not appear to be wearing clothes.

The equity market collapse and the clumsy efforts in terms of intervention and crackdown on individuals, including reporters, have shaken China’s reputation. The policy response to the Tianjin tragedy was disheartening at best and revealed the authoritarian fist that is often hidden by the commercial glove.  

Its declarations to the contrary, Chinese officials have still not truly allowed market forces to drive the yuan though it has managed to close the gap between the spot market and the central reference rate. There is little transparency of the intent of Chinese policy makers or confidence that they have the technical ability to manage what PBOC Governor Zhou referred to as a “burst” to the G20 meeting.

Third is the Federal Reserve. Despite efforts to increase transparency, and the clear communication style of Yellen, the uncertainty over Fed policy was cited in reports from the G20 meeting as contributing to the market volatility. The market, judging from the September Fed funds futures contract, has all but given up on rate hike this month. The contract has closed at an implied yield of 17 bp for the past three weeks. The effective rate, a weighted average, which is what the contract settles at, has gravitated around 14 bp in recent weeks.

However, if the Fed were to raise rates on September 17, it would hardly be a surprise. Slightly more than 80% of economists surveyed by the Wall Street Journal in July and August anticipated a September lift-off.  At 5.1%, the unemployment rate is lowest it has been for decades, with a few exceptions, and within a range that the Fed believes is consistent with full employment. Broader measures of the labor market confirm that conditions have steadily improved. 

Yet, the Fed seems hesitant. The IMF has cautioned against a hike this year. The price stability mandate, operationalized to by 2% a year increase in the core PCE deflator, remains elusive. The driver of core inflation is thought to be wages, and wage growth has been lackluster compared with past business cycles.    

On top of this, some Fed officials, notably NY Fed President Dudley, that the international and financial market developments, made a September move “less compelling.” Dudley also seemed to suggest that the August employment report would not capture the impact of more recent developments, the Vice Chairman of the Federal Reserve suggested the report would provide a key data point.