Mercantilism Moderation

From David Simmonds, RBS,

We condense the uber dovish end March message from Fed Chair Yellen to the following:

Policy divergence is unwelcome because it strengthens the dollar. A stronger dollar is unwelcome because it lifts global market volatility. That is unwelcome because it tightens global financial conditions and because it forces painful delevering on emerging markets that have borrowed dollars heavily throughout the post crisis, QE period. That is unwelcome because emerging markets contribute most at the margin to global growth and downside risks to tepid global growth can come back and bite the US.

From this we draw two conclusions:

First, global market volatility should be resuppressed for longer; second, the policy divergence driven stronger dollar story is decisively undermined as the Fed Chair puts the dollar front and centre of her macro policy thinking to an unprecedented (as far as we can recall) extent. There may be something else going on that reenforces the volatility suppression story which we might call ‘mercantilism moderation’. Markets are gaining some creeping sense that some kind of informal agreement has been reached; that there is a kind of quid pro quo by which, in return for a very dovish Fed, other countries have agreed to tone down the verbal FX intervention, a ceasefire in the global currency war. Potentially, that is a volatility crusher for longer. But markets will test tolerance levels around any currency truce with the immediate focus on the strengthening yen.

Here is Themos Fiotakis, co-head of FX and rates strategy at UBS,

We have not been wrong on the economics, which justify a weaker yen. Incoming data strongly support the need for BoJ stimulus and a weaker currency. Activity is slowing, inflation expectations are falling, and financial conditions are tightening.

The path to sufficient stimulus has been rockier than we expected. Despite February’s sharp [rally in the yen], the BoJ did not act at the March meeting, and the rhetoric has been passive and confusing. Many, including us, have held the view that ultimately policy will step in, limiting the downside in the dollar against the yen. But continually dropping lower without a policy response has likely made investors more eager to test the BoJ’s resolve.

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