The Fed’s annual economic symposium will kick off on Thursday, but the highlight will be Chairman Powell’s flagship speech on Friday. With US yields trading at their highest levels of this cycle, his signals on interest rates could either add fuel to this rally or trigger a correction, driving the dollar accordingly.
Fed summer camp
Once every year, Fed officials are joined by foreign central bankers and academics at their summer retreat in Jackson Hole for a symposium to discuss monetary policy and economic trends. Since this platform has been used in the past to signal major strategy shifts, markets see it as an unofficial FOMC meeting.
As such, the emphasis will be on what Jay Powell says about the path of interest rates. Futures markets currently assign only a 15% probability for another rate increase in September, even though incoming data has been particularly strong in recent weeks.
Economic growth is tracking at a 5.8% annualized pace this quarter according to the Atlanta Fed, consumers continue to spend, and the unemployment rate remains subdued near a five-decade low. Meanwhile, home prices are hitting new record highs in many parts of the country, so the cooldown in rents that the Fed has long awaited might prove elusive.
In other words, the US economy is running hot and with energy prices also moving higher lately, there are credible concerns that inflation might not cool down to its 2% target anytime soon.
What can Powell say?
Overall, Powell is likely to keep his options open. While there has been serious progress on the inflation front, core inflation still running at 4.7% and with several signs it might remain elevated, it is probably too early for the Fed chief to take a victory lap and declare ‘mission accomplished’.
He was preaching data dependence at the July FOMC meeting three weeks ago and will likely maintain that approach. However, considering the strength in the data flow lately, the risk is that he strikes a more hawkish tone this time, emphasizing the prospect of a ‘higher for longer’ regime for rates.
If Powell puts more emphasis on the prospect of keeping interest rates elevated for a longer period or on raising rates again in September, that could amplify the upward pressure on US yields, turbocharging the dollar.
Dollar/yen is extremely sensitive to rate differentials, as the Bank of Japan still has not raised rates, so any spike in US yields might be reflected in this pair the most. A potential break above this year’s high at 146.60 could add momentum to the pair’s upward trend.
That said, Japanese authorities will likely become more vocal about FX intervention if dollar/yen approaches the 150.00 region in a hurry, so any advances might not be linear.
The big picture
All told, the outlook for the US dollar seems promising. With real US yields hitting their highest levels since 2009 this week, the dollar is becoming an increasingly attractive investment destination.
And this upward pressure on yields is unlikely to fade without a crisis. The Treasury is flooding the markets with new debt issuance, the Fed continues to unwind its own bond portfolio through quantitative tightening, and there are whispers that even China is unloading some of its Treasuries to raise reserves and defend its sinking currency.
On a simpler level, the US economy is superior to its competitors at this stage from a growth perspective. China is battling a severe economic slowdown and business surveys suggest Europe is headed downhill too, perhaps towards a technical recession later this year.
Over time, this economic divergence between the world’s largest economies is likely to be reflected in exchange rates, especially if US yields rise further.
