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Forex: Bernanke Bias To Pause Prompts Theme Changes - Return Of Weak Dollar Trade

Bernanke Bias To Pause Prompts Theme Changes - Return Of Weak Dollar Trade

Bernanke has exposed the dollar to some significant downside risk...markets now know that his desire to pause, first expounded at the JEC testimony in late April, is very much alive, despite upward pressure on core inflation and tight capacity. Data evolution have yet to persuade the new Fed Chairman and presumably the majority of the FOMC voting members that the economic forecast of the spring and early summer needs revising. Bernanke said inflation will slow, as the US economy slows, in coming quarters. Indeed Bernanke was quick to note that the Fed's assumption that growth would slow is already showing up in the data, namely consumption and housing investment (cooling real estate market).

However, Bernanke is not ruling out a more significant inflation surprise ahead and he and the FOMC remain ready to deal with upside surprises on inflation ahead with more tightening. Not even the June core CPI gain at +0.3% m/m, for the fourth straight month, has forced the Fed to revise +its outlook, which seemed to surprise markets Wednesday, nearly fully pricing in an August 08 rate hike only to unwind this expectation to slightly more than even odds of an August tightening.

The volatility in asset prices and currencies Wednesday was all about the disconnect, not the Fed being soft on inflation or writing off core CPI to the false signal generated by owners' equivalent rent. The disconnect is the market, by its very nature, as a casino has to take disproportionate bets around key pieces of events and data when volatility is highest and potential gains the greatest. It matters little that the Fed is thinking longer-term and not prone to adjusting its basic outlook for inflation and hence official rates on the difference between 0.2% and 0.3% gain in core CPI. In the drive for profits, Markets naturally attribute more significance to single data points than reason would suggest. The issue that could be exploited on Wednesday was not betting on a 0.2% or 0.3% reading, but the disconnect. The fact that the Fed is not short-term and Bernanke in particular is not prone to micro-managing expectations to the extent that his predecessor did...a lesson that many are having a hard time learning.

That said an August 08 rate hike is very much a possibility. The more closely observed core PCE price index is out August 01 and a confirmation of higher core inflation in this report may prove more difficult to ignore. But that too is not far from the same disconnect that happened Wednesday. True. But there is a point in the evolution of data that the forecast changes and it may be the June core PCE price index that does it.

After all, even Bernanke this week said the Fed still approaches policy using Greenspan's risk management approach (just bit more model driven than discretionary). Taking Fed funds to 5.50% from 5.25% in August may be just the kind of insurance policy on inflation that the move to 1.00% was on deflation a few years ago. And even a growth-biased Bernanke can find comfort in an eighteenth straight rate increase knowing that foreign demand and domestic business investment are firm and cushioning against a hard landing from the overshooting risk.

But it is equally possible that the Fed indeed pauses in August if data pile up showing a slower growth rate and modest core inflation gains in the next three weeks. Moreover, what markets demonstrated yesterday is that Bernanke is free to do as he sees fit without compromising "street credibility" - TIPs spread did not widen on his "dovish" testimony nor did the long end of the curve weaken. Both would happen if the Treasury market felt the Fed was compromising the outlook for inflation by a predisposition to pause.

While I think an August tightening or pause is roughly a coin toss in terms of likelihood (subject to change in next three weeks), I don't think it matters much for asset prices and the dollar. One or even two (now looking like the outlier forecast) more rate hikes is not going to change the message - the Fed wants to pause and sees real slowing and a moderation in inflation ahead.

So as a prop for the dollar, the official interest rate theme is really at risk of diminishing marginal support for the buck. And it is worth noting that late cycle tightenings by the Fed are not typically dollar supportive as markets price in future rate cuts, as is the case currently (2007).

Moreover, even modest tightening from the BoJ ahead against a near-done or done Fed will in time lead even the yen up vs the dollar. More immediate is the growing pressure on the ECB to tighten (Garganas today seemed to imply the ECB is at risk of falling behind the curve on inflation). Indeed an August 03 rate increase is a near certainty, and some risk it may be a half point in size versus the normal quarter point moves.

In time price generates themes and news...the lower the dollar drifts on a Fed pause and Fed easing (2007), the more attention markets will give to the imbalances theme - US external deficit (contrary to some claims it is not improving) demands a lower dollar and market participants have two major reasons for selling the US currency. Remember it was the April G7 meeting in Washington along with the Bernanke JEC testimony the following week that launched the dollar decline this spring. The DC meeting brought global imbalances and adjustment to the forefront of market concerns. And it was clear that apart from Breton and MoF, officials seemed resigned to the fact that the market in time would take the dollar lower against most currencies, and G7 should be prepared to check any tendency toward a disorderly dollar decline. Well Bernanke helped end that trade by getting caught out on the pause message from the JEC and had to do what most new Fed Chairman have to do in early days on the jobs...hike rates to win some respect from markets. Now that that is done I can see a return to the spring dollar market. And G7 meets again in September (when the risk of a Fed pause goes up exponentially) to revisit imbalances and anoint the IMF as the new global currency cop looking for misalignments and unfair FX regimes. Between the likelihood of a Fed pause and G7 and IMF again worked up on adjustment (insurance against protectionism going into the US mid-term election in November), the weak dollar trade should make a marked reappearance.

David Gilmore
FXA
www.fxa.com