USD weakness continues but no help to equities as Fed falls behind the curve

Week ending Friday July 28th 2017

The slump in the USD continued for a third week. This time it was only domestic drivers as the FOMC statement sparked a strong downward move of 0.5%, before a gradual recovery later on hopes of a Trump victory on Obamacare. This recovery was then crushed on Trump’s Obamacare defeat and less than sparkling GDP estimates.

There was only a small movement in bond yields over the week but the dashing of any lingering near term rate rise expectations (and a move to only 50/50 for a rate in December) on the FOMC statement indicated that it was FOMC “dovishness” that caused the move in the USD.

Not really dovish at all

Worryingly, equities did not respond to the FOMC statement or weakness in the USD indicating that the strong run in the S&P500 was coming to an end. It also indicates that the FOMC while appearing dovish may actually be being hawkish, through not being “dovish” enough for the economic circumstances. This somewhat unusual situation has been seen a few times before, most notoriously in 2008, when the FOMC though it was being dovish cutting rates or not raising them in the face of high headline inflation only for economic prospects to be falling so fast that the Fed got way behind the curve.

Somewhat foolishly, the Fed is a bit like that today, still worrying about getting behind the curve in the face of their expectations for a surge in wage inflation. They are so wrong. They base themselves on the false Philips Curve notion of tight labor markets causing inflation rather than inflation being caused by monetary easing.

Dangers lurking for the economy from a blinded Fed

That 2008 disaster was the result of headline PCE inflation being well above Fed target, even though not being a Fed target. The actual implicit target of core PCEP PI was hovering around 2% quite happily. The cause of the blip was merely a one-off rally in oil prices. Is history repeating itself this week with crude prices nearing $50?

We don’t expect oil prices to continue to rally due to our scepticism over the power of OPEC, but you can never be sure. We are worried that the Fed, desperate to see its false Philips Curve model validated, will grasp at any straws that come its way, even temporary oil price rallies.

Patchy data and surveys confirmed by lacklustre 2017Q2

RGDP came in on expectations at 2.1% YoY but revisions down of the prior quarter disappointed. NGDP was also dull at 3.7% YoY and duller still was the “truest” measure of inflation, the GDP deflator. The latter is running at 1 6% YoY and just 1.1% QoQ annualised.

Current month just ending surveys were dull. Next week we get the first concrete data for July with the payrolls plus several more surveys. No changes in dull trends are likely, but there is always the possibility of bad news appearing and upsetting markets given the Fed is now increasingly seen as behind the curve, not relative to inflation but relative to the weakness of the economy.

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