In early 2016, the permabears — economists and others with consistently negative views of the economy — were again forecasting a global recession and financial catastrophe. So, it was ironic that as their pronouncements reached a peak, there was a bottom in the negative momentum created by the dollar’s sharp rise and the plunge in oil prices during 2015. Indeed, when almost everyone decided that central banks were ineffective, their accommodative policies significantly reduced real long-term interest rates in the United States and abroad, thus raising economic momentum.
Key to the permabears’ Armageddon-like vision was an assumption of a sustained uptrend in the dollar that they believed would force a massive devaluation in the Chinese yuan and unleash commodity deflation. Instead, by early May, the dollar had stabilized, the yuan had proved resilient and the commodity downtrend had reversed. Still, the dollar’s adjustment, from about 25% undervalued to roughly fair value in May, was tough on commodity markets, U.S. manufacturing exports and multinationals’ foreign earnings. Yet, those adjustments are largely behind us now, and the positive impact of lower oil prices and a more balanced global growth mix are becoming apparent. As a result, there is no sign of a recession on the horizon.
The fed’s policy has fostered a long recovery, low inflation and full employment.
The bearish vision of a soaring dollar was predicated on the notion that central banks were locked into a counterproductive, mutually destructive path — yet another example of misguided views that have appeared since the financial crisis (similar to predictions of hyperinflation due to the Federal Reserve’s quantitative easing, or QE). Instead, the Fed’s policy has fostered a long recovery, low inflation and full employment, with little evidence of equity-market bubble valuations. As those predictions failed to materialize, the permabears said that central banks had run out of ammunition, which The Economist hinted at earlier this year.1
What turned things around?
The strong dollar substantially tightened global financial conditions late last year, obviating the need for as much rate “normalization” as had been previously expected from the Fed. Similarly, rhetoric and policy in other countries shifted to moderate currency depreciation. The first big shift in this direction was the European
Central Bank’s (ECB) disappointing December easing, which caused the euro’s unexpected rise. The Bank of Japan’s (BoJ) shift to negative rates had a similar effect on the yen in January. China did its part by resisting calls for a destabilizing devaluation. Instead, it stuck to its trade-weighted currency basket — focusing on the euro and the yen, whose recent relative strength diminished the pressure for depreciation of the yuan against the dollar. Also, China’s shift from goods exporting to domestic-demand and services should benefit from a strong currency, negating the need for a massive devaluation of the yuan.
A key point missed in the market’s “currency wars” narrative was that currencies had settled into a more favorable pattern for growth. Because the U.S. adopted QE early and aggressively, the dollar fell two standard deviations below fair value, helping the U.S. economy to recover before the economies of reluctant QE adopters like Europe and Japan. After 2014, the dollar returned to fair value, helping shift global demand from the U.S. to Europe and Japan precisely when the Fed needed to remove accommodation. Basically, the stronger dollar had an effect similar to U.S. rate hikes, helping keep interest rates lower than they otherwise would have been.
Since the dollar and oil accounted for most of the earnings momentum decline over the past year, their stabilization has set up an earnings inflection point, which global equity markets appear to reflect. Barring any significant increase in the dollar, which is unlikely given its sharp run-up since June 2014, the global economy is positioned for faster growth.
Lower real rates
The real 10-year Treasury rate was deeply negative before the Fed signaled that it would taper its QE program in 2013. Now it is at the low end of the higher, but barely positive, range that has prevailed since the late-2013 “taper tantrum,” dropping from about 0.8% to 0.2% since early 2016 as expectations for Fed tightening have diminished. In turn, lower real rates have capped the dollar’s rise. (See “Stable Dollar Good for Global Growth,” above.)
Lower interest rates abroad also helped lower U.S. rates. As long as inflation is contained, negative yields on most high-quality 10-year sovereign debt will be a strong anchor on U.S. yields, which stimulates the economy.
In addition, some homeowners are starting to tap their restored home equity values for renovations. What’s more, millennials’ shifting from apartments to single-family residences is driving double-digit growth in residential investment.
What it all means
We have seen a mid-cycle transition rather than the prelude to a recession. The global economy is rebalancing, with a higher dollar and lower oil prices coming at the right time to increase global demand and stimulate economies through weaker currencies. The U.S. economy has benefited from the restraining influence of the stronger dollar at a time when full employment is the main threat to expansion.
THE STRONGER DOLLAR HAD AN EFFECT SIMILAR TO U.S. RATE HIKES, HELPING KEEP INTEREST RATES LOWER THAN THEY OTHERWISE WOULD’VE BEEN.
Expectations of recession have proved groundless, as was the case in 2011, the mid-1990s and the mid-1980s. In those instances, when financial conditions tightened and fears of recession rose without much inflation threat, the Fed eased and expansions continued for several years. It did the same in March, when its expectation for short-term interest rates shifted down, reflecting less need for tightening. This is another example of why market veterans “don’t fight the Fed” and regard magazine covers as contrarian indicators.
1 “The World Economy: Out of ammo?,” The Economist, Feb. 20, 2016.
Photograph of The Fed by Traveler1116/Getty Images
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