China still holding down US rates?


Alan Ruskin of Deutsche Bank AG argues that market instability gives an additional constraint to the US dollar’s appreciation. Namely, that:

  1. Currencies have been elevated in the Fed’s reaction function because a strong
    dollar is working through a wider range of conduits and affecting US financial
    conditions more than in past cycles.
  2. Asynchronous EM and DM country business cycles, and sharp output gap
    differences between DM countries, still favor USD positive policy divergence in
    the medium term.
  3. In prior cycles a strong dollar’s impact on U.S. trade accounts was the main
    constraint for further appreciation. But this time the impact of a strong USD on
    market stability will restrain the dollar.

From MarketWatch today,

There may be a “lull” under way in the currency wars that have seen the world’s central banks taking action to weaken their currencies in a bid to gain an advantage against their global trading counterparts.

But it isn’t yet clear that authorities have beaten their swords into plowshares, according to Alan Ruskin, macro strategist at Deutsche Bank, in a note this week.

Ruskin, you may recall, made some waves last month by urging that global economic policy makers revisit the 1985 Plaza Accord—an agreement struck by the U.S. and other major industrialized economies to stem the rise of the dollar DXY, +0.10%  and ease currency-related tensions. Other analysts also chimed in, urging some kind of pact as policy makers from the developed and emerging economies met in late February in Shanghai.

That meeting came and went without any earthshaking public pronouncements. But subsequent policy moves by major central banks, particularly the European Central Bank, the U.S. Federal Reserve and the People’s Bank of China, seemed to convince many investors and market watchers that authorities must have made some sort of pact to tamp down tensions.

[…] Ruskin, in his latest note, says it’s clear that the “feedback loops” from a strengthening dollar “has elevated the [U.S. dollar] role within financial conditions, and at the margin made the Fed more dovish.”

This is getting difficult to model, but bear in mind that China’s central bank has weakened Renminbi by the most in more than two months against the dollar, and according to the FT, “sparking speculation the move was an attempt to get ahead of any monetary tightening by the US next month”.

Last year, the Fed specifically quoted Chinese concerns. This year, the Fed’s policy will still need to take into account China’s past and anticipated movements. So like it or not, China’s monetary policy is an endogeneous factor in the Fed’s decisions.

In addition, the Yuan has ambitions to woo investors. DB Asia’s strategists led by Perry Kojodjojo commented on China’s possible inclusion in the GBI EM Global Diversified Index. According to the report, they “recognised parallels with the opening of the Shanghai Hong-Kong Stock Connect as a route to MSCI benchmark inclusion”. For China, its stubborn attachment to the dollar means that it is more difficult to achieve a stable trade-weighted rate. Thus at this point, it is a guess where China’s central bank will take this to – more confusing currency management or greater credibility for its currency?

The thinking is that currency depreciation would be enough to channel trade and stimulate growth in one’s country. Post crisis however, this “magic dust” is losing its potency and hence contrarily, more of it will need to be employed just to have the same effect. In other words, this is a zero-sum game for all countries whether emerging or developed. Nonetheless, pursue this they will, and that is why there will be a constraint as to how far Fed can raise rates.



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