Lower Rates, Higher Dollar?
Featuring Joseph Trevisani
Published on: July 15th, 2019 • Duration: 14 minutesJoseph Trevisani, senior analyst at FXStreet, reflects on Jerome Powell’s recent testimony to congress and discusses what traders should expect at the next FOMC meeting. He notes the current issues with the Phillips curve, explains how other central banks could react to a dovish Fed, and reviews why the euro should weaken by the end of the year, in this interview with Jake Merl. Filmed on July 12, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl, sitting down with Joseph Trevisani of FXStreet. Joseph, great to have you back on the show.
JOSEPH TREVISANI: Thanks for having me.
JAKE MERL: So, today, we're going to be talking about the Fed. We just have Powell give his testimony. And we also, at the end of the month, have the FOMC meeting where they might cut rates. And so, we wanted to get your view of Powell's testimony and how you see monetary policy affecting markets in the weeks and months to come.
JOSEPH TREVISANI: The Fed is in a very interesting position. They are considering a rate move quite seriously. In fact, they have set it up so with their devotion to transparency. They don't really have a lot of choice. The markets have fully priced it in, so it's something that they need to do. The Fed is not going to want to create the market repositioning that will happen if they don't cut rates at the end of the month.
On the other hand, they don't have a very strong economic rationale, at least not one based in the United States. Traditionally, if you have an economy that's growing somewhere between 2% and 3%, that seems to be steady and stable at that level, you really wouldn't consider cutting rates. If you have inflation running somewhere between 1.5% and 2.1%, 2.2%, you also wouldn't normally consider cutting rates. If you have a very hot job market, which we do, yet there's really not overriding wage inflation, you wouldn't consider cutting rates, but the Fed is going to do this.
So, we have to look. And I think they found a- maybe not more acceptable, but a good economic rationale, almost a socioeconomic rationale. What Mr. Powell said was that the wages were not growing really fast enough to support inflation, to drive inflation higher. And that's correct. However, wages are improving at a better rate than they have and also disposable income at a better rate than they have, at the best rate they have since the recession. And I think that's the focus, because if the expansion slows down, or stops or goes into a recession, or a mild recession, you will lose all of that wage pressure.
And as he said, a number of times, that wage pressure is benefiting classes in society that have been left out for many years. And it has a farther reach than it has before meaning to people who had not been employed or marginally employed. So, those are rather large socioeconomic benefits, ones that fit exactly in the feds mandate from Congress for full employment. So, I think the focus on that to keep the expansion going, in effect, to take out an insurance policy on the expansion is what the Fed is aiming at. And I'm pretty sure they'll do it.
JAKE MERL: But do you think rising wages will directly translate into a rising inflation?
JOSEPH TREVISANI: Well, that's another interesting thing. And I think the house testimony, the Congresswoman from New York, Miss Ocasio-Cortez, brought up the Phillips curve, which is a very accurate question. Surprisingly enough, I suppose politically, at least Larry Kudlow, the President's economic advisor preached her for it. And the idea is one which seems logical. Phillips curve dates from the 1950s, late '50s, early '60s. And it postulates that rising employment, a tighter labor market, falling unemployment, will naturally enough force employers to offer wages, higher wages. This translates over time into inflation- both wage inflation, and then of course, price inflation.
It has a seductive logic to it. It seemed makes sense. It hasn't really worked out terribly well, empirically. But now, because the- and the environment, the global environment that you're in in the 1950s and 1960s really did not have a great deal of offshoring. People didn't move their factories to Malaysia or to Indonesia or to China. So, the logic was at least domestic. Now, the global market means there's also a global competition for wages and global competition for labor.
So, one of the great puzzles- well, it's actually not a puzzle, but from Fed policy point of view, which is based on monetary policy, you increase the money supply, you get inflation, hasn't worked. If you look at the inflation record since the recession and the amount of money that was pumped into the economy through lower rates and also through quantitative easing, got a very little inflation. The link, however, it was functioning in the past, and now, almost completely broken. So, that was her point.
And so, I think that is true. So, the Fed can lower rates, which will give a boost, a benefit of support to the economy without worrying a great deal about inflation. I think that was both of their points, surprisingly, in agreement.
JAKE MERL: And so, you think at the upcoming meeting in July, we're getting a 25 bips cut? Is that what you think?
JOSEPH TREVISANI: I think we will. If they're going to take out an insurance policy, it's almost more of a psychological insurance policy for business. Consumer spending has held up reasonably well. It dipped and then it's come back. Business spending and business sentiment, which is one of the underpinnings of the economy, has not. It has fallen and stayed relatively low. I think businesses are a lot more worried about the global economy and about China and perhaps about Brexit. Maybe they're going to like Boris Johnson, I don't know, I don't see that. But you never know.
Then consumers are. Consumers are looking at low unemployment, ease of getting jobs, more jobs than there are people to fill them and rising wages, and low inflation. So, from a consumer point of view, what's not the like. But it's the businesses that are more concerned. So, in a way, I think this will do more, perhaps for the psychology of business, because after all, a 25% interest rate cut in the Fed Funds Rate is really not going to do very much as far as driving greater growth, but it might drive some sentiment, which in turn, could provide some more business spending.
JAKE MERL: So, bringing this back to trading and investing. How do you see this all impacting markets, and specifically, the US dollar over the weeks and months to come?
JOSEPH TREVISANI: The judicial view and at two weeks ago, a little more, the dollar took a dip when this became more credible. It's been credible for a while. Let's look at the Fed Funds Futures, have been at 100% on and that's a volatile measure. But nonetheless, it's been 100% for probably two months, maybe more. I'm not sure about that, that they're going to reduce at least by a quarter. So, the dollar, of course, lower rates to that.
In addition, the Treasury rates have been coming off since early November. If Treasury rates started to fall six weeks before the Fed raised rates the last time in December, they raised I think, on the 19th of December, Treasury rates have been falling since the 8th or 9th of November. So, the credit markets had a very different view than what the Fed actually did. So, that, of course, has an impact on the dollar.
Throughout all of that, the dollar has held up reasonably well. And in fact, it popped over 1.13 to the euro last week, an ounce back underneath. What's going on, of course, are twofold. One, if the Fed is worried about the global economy, so is everybody else. So, if the Fed is going to start lowering rates, so is everybody else. The only people who are being resistant right now are the Canadians. They also have a very strong economy, a very strong labor economy, surprisingly strong.
They just set an all-time record, I think for the number of jobs created in one month two months ago. Why? But it's a very impressive feat. So, one, you're going to get the other central banks looking at- and Mario Draghi has said this, he's headed to retirement and he's probably going to get another really nice job too. Christine Lagarde is going to take his position, another very nice job. So, the other central banks are going to move to- they're going to come with the same analysis. They're going to come to the same reason for doing that, lower rates. The Australians and the New Zealanders have already done this.
In addition, all of the trading currencies, a trade against the dollar, don't really want their currencies to revalue, to go higher appreciably against the dollar. So, there's that pressure as well.
JAKE MERL: So, it's a race to the bottom?
JOSEPH TREVISANI: Exactly. So, it's the standard thing. It's what usually happens. There used to get, 25, 30 years ago, divergences in rate policy between major central banks. You don't really get that anymore, much as the labor market has become not quite a global Phillips curve. But it's trending in that direction, or at least a global market. American workers really do compete against workers in Vietnam and against workers in China and Indonesia. It's the same thing with bank rates, they are very much in line when someone starts moving, especially when it's the Fed, because the Fed being the world's largest having the most impact when they're based on the world's largest economy.
JAKE MERL: So, you're saying even though the Fed is about to cut rates that the dollar should actually stabilize or strengthen from here?
JOSEPH TREVISANI: I think it probably will. Because what we're seeing here are two things. One, the US economy is still doing better than everybody else. And two, the Fed rate cut the end of this month, if it happens, is fully priced in. Everybody's known about this. Everybody's talked about it. Everybody's priced it in for months now. Some of the other major central banks, primarily ECB, has recently started talking about it. But there's no move.
Mario Draghi said, I believe that they could lower rates, well, they can't actually lower rates because they're already at zero. But they could certainly do- they could start up their quant. They could buy more bonds. They could do whatever they were doing in the past. So, but that's not at the operational level yet that they're not actually contemplating it. When that becomes something that is looming in effect, then, of course, that's a new factor in the currency equation. And it would play to the dollar strength, it would lower the euro. So, that's why I think it's still possible.
JAKE MERL: So, how much upside do you see for the dollar? Or how much downside to see for the Euro?
JOSEPH TREVISANI: Well, that's a little difficult. I'm still looking for the- we're at about 1.1250 right now in the euro. I'm still looking at between 1.05 and 1.07 by the end of the year. I still think that's something that, given the current and the trends that we're seeing, both as far as the central bank rates go and the world economy, something that seems likely.
JAKE MERL: And what would be the biggest risk to that thesis?
JOSEPH TREVISANI: The biggest risk is that the Fed gets more worried than they are and in the end, you get a move to more than one. I think what you're going to get right now is one is 25 basis point cut at the end of this month, on the 31st. And then I think they're going to move back to a pause, a neutral and see what happens. If that is not the case, if the China trade issue becomes more volatile and more acrimonious, and you have more tariffs on both sides, that would be a risk for that. Because the Fed will undoubtedly respond to that by reducing rates against it.
JAKE MERL: And so, just in case things don't go your way, would you have a stop loss in that trade for the Euro?
JOSEPH TREVISANI: Yes. I would put it about 1.15. Because if you get to that point and there has been a serious alteration in the underlying economics and the underlying rate policy, so something has changed. Because if you look at the currency charts, they're pretty much wandering around and have been for more than six months in a very tight range. The basics haven't changed. The fundamentals, the things that drive long term trends and currencies and in markets as well haven't really changed. And you know that just looking at the charts. So, if you get to 1.15, things have changed.
JAKE MERL: Well, Joseph, that was great. We'll see how it plays out in the months to come. Thanks so much for joining us.
JOSEPH TREVISANI: Thank you very much for having me here.
JAKE MERL: So, Joseph is bearish on the euro. Specifically, he likes shorting it at current levels with the stop loss at 1.15 and a target between 1.05 and 1.07 by the end of the year. That was Joseph Trevisani of FXStreet and for Real Vision, I'm Jake Merl.