- Reuters/Akhtar Soomro
- The Trump administration’s de facto weak dollar policy may be exacerbating market volatility.
- A strong dollar policy has allowed the Fed to keep interest rates low for a prolonged period, argues Rebecca Patterson of Bessemer Trust.
- Fears of inflation linked to a falling dollar are driving up bond yields and fueling expectations of potentially four interest rate hikes from the Fed this year.
Financial markets around the world are in a tizzy as higher Treasury bond yields have prompted fears the breathless run-up in stock prices has climbed too far.
But there’s another, less prominent factor, underpinning renewed market volatility, which is affecting asset prices around the globe: fears of a currency war started by US official rhetoric on the benefits of a weaker dollar.
“A strong currency puts a lid on inflation and helps keep interest rates low,” writes Rebecca Patterson, chief investment officer of Bessemer Trust, in a CNBC.com opinion piece.
In its absence, yields on 10-year Treasury notes, which move opposite to their price, have surged to a four-year high above 2.8%, while stocks posted their sharpest one-day point decline since the financial crisis Friday.
Treasury Secretary Steve Mnuchin sent the strongest signal yet last week in comments welcoming the dollar’s decline as beneficial to US exports. The comments were highly unusual for a Treasury secretary and came on top of new protectionist tariffs on solar panels and washing machines – and thus seen as part of a bigger policy agenda.
“It’s the beginning of at least a verbal currency war,” Nouriel Roubini, professor of economics at New York University, told Bloomberg Television. “Fundamentally this administration wants a weak dollar.”
The Fed’s role in market volatility
Many investors have worried that after years of market volatility being suppressed by ultra-low interest rates around the world, the good times were bound to come to a hard landing. Wall Street is clearly trying to figure out whether this is the big one as the Fed gradually pushes official borrowing costs higher. It has raised the benchmark fed funds rate five times since December 2015, to a range between 1.25%-1.5%, having left them at zero for seven years.
There’s reason to believe markets are getting ahead of themselves. After all, underlying the selloff is the fear that an unexpected bout of inflation generated by the combination of a tax cut package on top of an economy that is already supposedly operating close to its full potential, will force the Fed to tighten monetary policy more quickly than expected.
Bond traders, who not long ago had doubted the Fed’s resolve to hike rates even three times this year, are increasingly betting that a fourth interest rate increase may be in the offing.
“There’s more of a risk that they go four times than two,” Lisa Hornby, fixed-income portfolio manager atSchroders Investment Management, told Business Insider.
Adding to the uncertainty is a changing of the guard at the Fed, and lack of clarity on how a Jerome Powell-led central hank will react to market ructions.
What traders might be ignoring is that any threat to the economy from higher yields or swooning stocks might themselves prompt the Fed to slow the pace of tightening – making the market’s current panic potentially premature.
One factor not in the Fed’s hands is currency policy, and that is being awkwardly managed at the Treasury.
Patterson explains the relevance of America’s long-standing strong dollar policy to the Fed’s ability to support the economy – and the risks of its abandonment by the Trump administration.
“A strong currency keeps a lid on inflation, which in turn helps keep interest rates low,” she said.
“Such easy monetary policy helps families and companies through lower borrowing costs, for mortgages and student loans, for example. It also helps reduce the amount of interest expense the U.S. government has to pay on (large and increasing) federal debt.”