A risk of more US dollar strength in the near term

US dollar might go up further as a result of monetary policy tightening.

The FED will go harder and faster than other major central banks because the consumer is in a much better financial place than we see in the euro zone or the UK. Much of this comes from the handouts given during COVID, but if we take financial assets into account as well, the sharp rise in asset prices, particularly stocks– up until this year– has helped financial net worth amongst households rise by some 30% since the depths of the COVID crisis in early 2020.

Admittedly, financial net worth has risen elsewhere. Households in the euro zone and UK have also seen their net worth rise, but it has climbed at less than half the pace that we have seen in the US, at around 12-13%. In short, US households have got a lot more savings that they can burn through before they really feel the crunch of higher US policy rates, and respond with slower spending.

Clearly, other sectors of the economy could weaken significantly and so counterbalance any lingering strength in consumer spending. But consumer spending is over two thirds of GDP, so it will take substantial weakness elsewhere to produce negative GDP. Perhaps ironically, the reason GDP fell in Q1 was largely down to robust consumer spending as this helped generate a huge 18.3% annualised rise in imports. The apparent robustness of the consumer in the US, abetted by the acute tightness of the labour market, suggests to us that the Fed will need rates of 4%-5% to bring inflation back to target; still higher than the Fed’s recently-revised forecasts.

Many will probably argue that the FED won’t have to go this far because it can use quantitative tightening as well. But the debate here comes back to an issue we have discussed many times before, which is as follows; is quantitative easing, or tightening, a "stock" concept, or a "flow" concept?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy sees it as a "stock" concept. That means that policy is loose if the FED’s balance sheet is in excess of the levels required to supply the economy with cash and banks with sufficient reserves. This excess comes down as quantitative tightening occurs and the balance sheet shrinks, so this excess comes down, but it is still an excess all the same. It is a bit like driving in the sense that a car still has forward momentum if the brake (QT) is applied gently and will only come to a stop when the brake is fully engaged.

Given that it is estimated that this "excess" FED balance sheet could be as much as USD 3 trillion and take up to three years to clear, it seems to us that real quantitative tightening won’t kick in until 2026. Now, clearly, other major central banks like the ECB and BoE have similar issues with QT, but the persistence of monetary stimulation through balance sheet policy will be more burdensome in the US than elsewhere. Because the consumer is more resilient and breaking the back of inflation will be harder as a result.

"This leaves us feeling that more tightening will have to come from a tightening of financial conditions, such as equity market weakness (to destroy some household wealth), higher yields (to raise mortgage costs), wider credit spreads (to make it more costly for firms to borrow) and a higher dollar," said Mr. Steve Barrow.

From here, the key question is whether this tightening of financial conditions will occur in a relatively benign way, leading to a modest weakening of the economy and (hopefully) a seamless transition to a state of lower inflation. Or whether the tightening of financial conditions will go well beyond the benign, caused by a Fed that has to be far more aggressive than anticipated. Or a FED that holds back and so provokes the persistence of inflation, which knocks the stuffing out of asset prices.

"We have always argued that the uglier outcome for the economy and financial markets is far more likely than the benign nirvana that the Fed and many investors hope for. If that is the case, the dollar will gain more strength; if not from rising rates, then from soaring risk aversion", Mr. Steve Barrow emphatically stated."