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Tags: dollar | fed | central banks | currency

Dollar Strength Reflects Divergence Between Fed, Other Central Banks

Dollar Strength Reflects Divergence Between Fed, Other Central Banks

Dr. Edward Yardeni By Tuesday, 10 January 2017 09:24 PM Current | Bio | Archive

US Dollar: Bullish Capital Flows. Interestingly, the word “dollar” was given importance equal to the word “fiscal” in the latest minutes, also with 15 mentions, up from seven in the minutes of the November 1-2 meeting. Fed officials are expressing some concern that the ongoing strength of the dollar could weigh on the economy, and even on inflation. That might allow them to continue to raise the federal funds rate at a very gradual pace even if the incoming Trump administration provides fiscal stimulus through tax cuts and some infrastructure spending. But it would rule out a more aggressive pace of monetary normalization.

The trade-weighted US dollar is up 26% since July 1, 2014 through yesterday (Fig. 1). It dipped at the start of last year, but has increased 9% since last year’s low on May 2. While the Fed raised the federal funds rate at the ends of 2015 and 2016 by 25bps each time, the ECB and BOJ continue to keep their official rates near zero. In addition, two or three more Fed rate hikes are expected this year. The 12-months-ahead federal funds future contract is at 1.14% (Fig. 2).

The ECB still has slightly negative rates on bank reserve deposits (Fig. 3). The ECB holdings of securities of euro area residents has soared over the past two years by €1.38 trillion to a record high of €1.97 trillion at the end of last year (Fig. 4). Reserve balances at the BOJ have soared 626% since December 2012 through December 2016 (Fig. 5). Meanwhile, the Fed terminated its QE purchases of securities at the end of October 2014 (Fig. 6). The federal funds rate is up 50bps since late 2015.

This divergence between the monetary policies of the Fed and the other major central banks is the reason the dollar is soaring. Much of the upward pressure may be attributable to foreign borrowers who are scrambling to pay off their dollar-denominated debts. The Chinese seem to be leading this pack, as we discussed yesterday and showed with our international capital flows proxy for China. Now let’s show what a similar proxy looks like for the world excluding the US:

(1) World ex-US capital flows proxy. We can construct such a proxy by subtracting the world’s 12-month trade surplus with the US (which is the negative of the US trade deficit) from the 12-month change in non-gold international reserves, which are held by all the central banks in the rest of the world (ROW) (Fig. 7 and Fig. 8).

This proxy shows significant capital outflows from the ROW to the US since the second half of 2014, just when the Fed started to signal that it was moving toward normalizing its monetary policy. Over the past 12 months through October, the outflows from the ROW to the US totaled $1.0 trillion.

(2) Implied capital flows & the dollar. Our proxy for world ex-US capital flows is highly correlated with the inverse of the yearly percent change in the trade-weighted dollar, particularly since 2005 (Fig. 9). Since the second half of 2014, the substantial outflows from the ROW into the US have driven up the dollar. Much of the inflow into the US probably reflects foreign borrowers repaying their borrowings in the US. The carry trade is no longer a profitable one for them, i.e., to borrow in the US at very low rates and invest the proceeds in higher-yielding assets overseas, particularly in emerging economies.

(3) International reserves & the dollar. Not surprisingly, there is also a very good fit between the yearly percent change in total non-gold international reserves and the inverse of the yearly percent change in the trade-weighted dollar (Fig. 10). The former was down 2.5% y/y during October. It’s been negative on this basis since December 2014.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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EdwardYardeni
Interestingly, the word "dollar" was given importance equal to the word "fiscal" in the latest minutes, also with 15 mentions, up from seven in the minutes of the November 1-2 meeting.
dollar, fed, central banks, currency
668
2017-24-10
Tuesday, 10 January 2017 09:24 PM
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