Key Takeaways
- Emerging market currencies continue to rally versus the US dollar.
- Gap in labor demand and supply may drag on recovery.
- The US housing market is on fire and doesn’t need Fed support.
What happened
The pandemic and FX market volatility have settled, for now. With half the US fully inoculated, pandemic fears have all but left the currency markets. The Deutsche Bank Currency Volatility Index (CVIX) is at its lowest level since late February 2020. Even so, the retreat in volatility may be short lived, as higher inflation numbers and changes in central bank policies will bring new considerations to FX markets and may likely generate higher volatility.
When bad news becomes good news. May’s Nonfarm Payroll numbers showed the market may be more focused on how the Fed reacts to the economy, rather than how the economy itself is performing. May’s numbers were 559k new jobs, below the economist median estimate of 675k. Stocks rallied on the news with the USD selling-off as investors saw the lackluster jobs report as a reason for the Fed to keep its extremely loose monetary policy intact until conditions trending toward full employment are in view.
EM currencies rallied as interest rates settled. After selling off in March, emerging market currencies rallied for the second consecutive month. This happens as the US 10-year rate hit a high of 1.77% on March 29 and has since traded down to below 1.5%. Markets digested the higher interest rates and as rates simmer down, risk appetite returned with several EM currencies appreciating in May: South African Rand +5.52%; Hungarian Forint +5.49%; Brazilian Real +4.19%, Polish Zloty +3.54%.
What’s at play
Inflation is here…for now? The fear over inflation has seen some proof. May’s Core CPI print (excluding food and energy) came in at 0.7% MoM and 3.8% YoY - the highest YoY figure since the summer of 1992. Yet, when you look more into the details of what contributed to this print, we see several categories making outsized contributions; Vehicle rentals +12.1%, Used cars and trucks +7.3%, airfares, +7.0% MoM. This should be no surprise given the surge of demand for post-pandemic travel and the reduction in new car production from a shortage of semiconductor chips that has increased the demand for used vehicles. The Fed has recognized inflation may run hot as the economy recovers, then expects it to be “transitory” as it normalizes near its target of averaging 2%. We’re still early into this recovery and supply chain shortages should normalize later this year, so will demand for travel. As higher commodity prices and pressure on firms to raise wages and lure employees back to work continue, the question is: will the longer-term deflationary forces of globalization and technology override this short-term blip? If not, the Fed will have to reverse course and look for a dollar rally on risk aversion.
With jobs aplenty, gap in labor market persists. As the pandemic fades in the US, the economy is roaring back with businesses hiring. Still, while the number of US job openings rose to a record high of 9.2 million in April, the US economy added only 559 thousand jobs in May. Continued federal unemployment benefits running through September may compel those out of work to delay their job search or remain out of the labor force completely, keeping the economy running at less than full capacity. The gap in the labor market could drag through the summer, resulting in mediocre economic figures and giving policy makers more rationale to continue their support. The added justification for loose fiscal and monetary policy is yet another factor for the USD to continue its downward secular trend.
Fed’s ‘Lower for longer’ interest rate policy portends downward pressure on the dollar. After the Financial Crisis, it wasn’t until 2015 with the unemployment rate at 5%, when the Fed raised rates. Now with the unemployment rate likely to fall from 5.8% and reach 5% soon (probably by Labor Day), the Fed’s commitment to rock bottom interest rates mean the dollar faces longer-term headwinds. The Fed’s commitment to keep interest rates low and lack of urgency to even discuss tapering means the USD value may continue to dip.
What’s next
The housing market indicates the Fed is out of touch with its policy results. The scorching hot US housing market is in no need of stimulus or support. According to Zillow™, average US home prices through April rose at the fastest pace since 2005, gaining 11.6% over the past year with April marking the fastest monthly gain in 25 years at 1.4%.1 Sound fundamentals driving the housing market look to continue: the adoption of remote work; first time millennial home buyers; low housing inventory; and low interest rates. Even so, the Fed is maintaining its policy of purchasing $40 billion of mortgage-backed securities each month to support the housing market and keep mortgage rates down. The Fed risks discrediting their own policy as being behind the curve and may potentially be unable to unwind stretched asset prices without a contraction. With asset prices at historic highs, a market correction could follow if the fundamentals behind this economic recovery fall off course.
Infrastructure bill will require first building bridges across the aisle. President Biden’s infrastructure bill faces two main obstacles from West Virginia: Senators Joe Manchin and Shelley Moore Capito. Manchin, a blue dog Democrat has kept the Biden Administration from passing its agenda and Capito represents the GOP in negotiations, where after reaching a middle ground of $3 trillion, talks have broken down. The result is we may not see an agreement for some time. Until an agreement is met and there is another large addition to fiscal spending, interest rates should settle down on prospects of a lower deficit. Should the current impasse continue, expect the dollar to weaken.
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