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Bound for the Plaza?
Thoughts in the currency market are turning toward the Plaza Hotel. The stately pile at the southeast corner of Central Park has a lasting place in American culture as the scene of Tom Buchanan’s confrontation with Jay Gatsby in The Great Gatsby; in the financial world, it has lasting fame as the place where world finance ministers and central bankers came together in September 1985 to agree on intervening to weaken the dollar against the West German deutsche mark and the Japanese yen. The effect was dramatic (if not as dramatic as Daisy Buchanan’s choice between her husband and her lover):
The ministerial intervention was successful and achieved what its backers wanted. The dollar has never regained its pre-Plaza highs from early 1985. But now, wishful thoughts are returning to the Plaza Accord once more. As the chart shows, the dollar is still far below its 1985 high in nominal terms. On a real effective basis, taking account of inflation, Citibank’s index show that it is almost back to its high since inception in 1989, after the accord was reached.
Some of the dollar cliches are true. Printing dollars does give the US “exorbitant privilege” (in the words of former French President Valery Giscard d’Estaing) and it is “our currency and your problem” (to quote President Richard Nixon’s treasury secretary, John Connally). And so it is that a succession of major economies have tried over the last week to rein in the US currency.
Last week, Japan’s Ministry of Finance intervened directly to avert the yen from falling beyond 145 per dollar; this Wednesday brought the Bank of England’s intervention in the gilts market, which also had the effect of arresting the pound’s descent toward parity; and on Thursday, the
In all cases, sharp losses for the home currency were more or less halted. None of the interventions has as yet have led to any kind of major reversal:
Interventions by three of the four largest economies outside the US in the space of a week show that the dollar’s strength is beginning to cause real stress. But there are at least two sides to any currency trade, and no meaningful limit to the dollar is possible without willing participation by the US. Hence the talk of a return to the Plaza. The logic is expressed as follows by Julian Brigden of Macro Intelligence 2 Partners:
We’ve discussed the growing use of policy as a thumb on the economic scale. Now, with volatility rising and some markets threatening to seize up, policymakers appear to have seen the size of the economic shark they are fighting and had the thought that, with apologies to Jaws, they’re “going to need a bigger thumb.”
If not a full-blown formal repeat of Plaza, there are at least hopes of a new version of the informal 2016 Plaza Accord, when dollar strength caused problems for China, and the Fed decided to hike rates only once during the year, rather than the four times it had previously guided the market to expect. The shifts in the financial tectonic plates are already causing alarm, while the Ukrainian conflict has driven a sharp devaluation for European currencies compared to the dollar. A strong dollar has also driven several emerging market crises in the past.
However, the story is more complicated. The Institute of International Finance points out that the dollar has been far stronger with respect to the developed world than to emerging markets:
According to the IIF’s estimates of fair value, the euro and the pound are still overvalued and have further to fall, despite the damage they have already sustained. That might vitiate any Plaza-style attempt to limit the dollar. And it also confirms that this dollar surge is likely to create more pain in western Europe than in the emerging world.
Beyond that, the forces driving the dollar are strong, and not going away. To quote Fiona Cincotta of City Index:
There’s nowhere to hide. There’s still some dollar strength to come. If we just think about what’s going on with the dollar, it’s being supported by safe haven flows, it’s been supported by a very hawkish Fed. It’s not showing any signs of really slowing down in that hiking cycle right now. And also, there’s no alternative... You don’t want to be going near the euro right now, given the energy crisis, the inflation troubles over the state of the economy... There’s nothing that’s appealing about the pound given the concerns over the outlook for the UK economy.”
Or, as Nick Carraway in Gatsby might have put it, the dollar is the pursued, and everyone else is pursuing, busy or tired. Weakening it would be hard. In any case, the US isn’t on board for doing so, for a list of reasons covered by Morgan Stanley’s economics team:
First and most importantly, a weaker USD runs counter to what the Fed and Treasury are trying to achieve: lower inflation. A weaker dollar is, on net, inflationary in the US and deflationary abroad; foreign currency appreciation supports higher external demand. While US inflation is elevated, it seems difficult to countenance why the US would proactively participate in an inflationary dollar policy, and without US participation, we see little chance of success.
Beyond that, they couldn’t do another Plaza if they wanted to, because of lack of ammunition:
We think that policymakers are aware of a hard truth: They don’t have enough FX reserves to make a sustained difference. Back in 1985-87, the last time we had a coordinated intervention to weaken USD, daily FX turnover was near US$200 billion per day (on a net-gross basis) but, as of the last reported BIS figure in 2019, daily turnover is over 40 times higher at US$8.3 trillion per day. The G10 collectively has US$2.8 trillion in FX reserve assets (deposits and securities, so excluding gold).
The bottom line is that despite the growing problems the rising dollar is causing for the world, we won’t be returning to the Plaza any time soon. The non-dollar economies may have each other’s company, but in another pearl from Gatsby, they must feel like “they are watching their whole world fall apart, and all they can do is stare blankly.”
If there is one obstacle to the Fed’s hopes to slay inflation (and also to the desire for the US to weaken its own currency), it’s the obdurate American consumer. Helped by a robust labor market and a formidable supply of pandemic savings and stimulus checks, they’re still spending.
The robustness of the labor market has many observers baffled. Using data on weekly initial claims for jobless insurance, a good but noisy indicator of hiring trends, it appears that layoffs are falling again. Initial claims seemed to have hit a bottom in the spring and started a steady rise (exactly what the Fed was hoping to engineer), but the latest data show they’re falling:
This keeps consumers spending. Aaron Clark, equity portfolio manager at GW&K Investment Management, speculates that companies are mindful of the difficulty they had rehiring people after the pandemic, and are trying harder to avoid layoffs than they would in a typical cycle:
It was so hard to hire that if they’re viewing this as just the Fed fighting inflation, then I think they’ll hold on to their workers longer than they might otherwise have done in a normal recession… They don’t want to now lay them off and then a year from now be trying to hire them back. So I think companies might be just willing to eat margins more and hold onto their workers in a slowdown.
Thus tighter monetary policy is not yet severing consumers from their jobs and their paychecks. Beyond this, the Fed is also hoping to create a “wealth effect” to bring inflation down — falls in asset prices will make people feel poorer and less likely to spend. But even the deepening bear market won’t derail any consumption in the next several quarters, according to Doug Peta, chief US investment strategist at BCA Research. Americans, he said, will spend enough to keep the economy afloat:
Empirically, changes in equity wealth have exerted little to no impact on consumption... Neither the equity bear market nor a softening housing market will stifle consumption. The Fed’s anti-inflation campaign will eventually induce a recession, but wealth effect concerns are overblown.
The graph below shows consumer spending on a near-perfect linear trend, barring the minor dip during the height of the pandemic in 2020, and an even shallower one during the Great Financial Crisis:
The mountain of excess savings US consumers accumulated across 2020 and 2021 have provided the foundation for their spending power. The wealth effect is real, Peta underscored, and household spending fluctuates depending on their current wealth. But the savings rate is low and declining, suggesting they are finding ways to keep spending.
What has a greater impact is changes in housing wealth, Peta said, citing a study by group of academics led by Yale University Nobel economics laureate Robert Shiller that analyzes the relationship between the consumer and home prices:
Changes in equity wealth exert considerably less influence over changes in consumption than changes in housing wealth. With a two-quarter lag, year-over-year consumption has changed by nearly three cents for every dollar move in equity wealth... The housing wealth regression indicates that every dollar of changes in housing wealth leads to a 38-cent change in consumption.
That housing wealth exerts a greater influence over equity wealth isn’t all that surprising, he said. Consider the geography. Nearly two-thirds of US households own their home — not to mention their homes being the largest asset for most people except perhaps wealthy families — while stock ownership is highly concentrated to a few. In fact, Peta pointed out that 50% of equities are owned by the top 1% of households by wealth.
Multiple data point to the resiliency of households, from credit card spending to consumer confidence, yet Luca Paolini, chief strategist at Pictet Asset Management, warns this may wear thin and that betting on endless consumer spending is “a very dangerous way of thinking”:
Inflation is rising more than incomes, and the savings that consumers accumulated during Covid are still high but declining. The outlook of the consumer is better than the outlook for businesses… but I think we shouldn’t overestimate the fact that the labor market is the last thing to drop. In every recession, the labor market is strong before it gets worse.
Nobody should extrapolate a strong US consumer long into the future, then. But the evidence is that consumer strength can last longer than anticipated. That’s good news for many, but also means at the margin that the Fed may need to keep rates higher for longer than it wanted.
Narrative Fallacy and the Gilts Market
I probably shouldn’t go there. But. Plenty of people are trying to argue that the gilt market implosion wasn’t caused by last Friday’s disastrously misjudged “mini-budget,” but by the Federal Reserve and global rising bond yields. There is a grain of truth to this, in that the gilt meltdown required underlying conditions of rising rates and elevated risk aversion. But it’s still absurd to say that the new chancellor of the exchequer’s decision to announce the second-biggest tax cut in UK history, with no information on spending cuts to pay for it, wasn’t the trigger for the implosion, because it was.
International conditions were and remain difficult, and it was obvious to anyone that bond markets were likely to revolt if the UK tried to embark on a new wave of borrowing. That makes the bizarre decision to press ahead more, not less, culpable.
It’s best illustrated with an analogy made 12 years ago by the great bond investor Bill Gross, the founder of Pimco. He said: “The UK is a must to avoid. Its gilts are resting on a bed of nitroglycerine.” That call was a tad early, but we can use the illustration. When Kwasi Kwarteng arrived at the Treasury, the gilts market was indeed resting on nitroglycerine. Inflation and rising rates meant there was every danger that it would explode. And he could see this clearly. Yet his first move was to light a match and blow it up. As the global market was so evidently troubled, his decision to press ahead is unforgivable. He didn’t put the explosive there, but it was his decision to light the fuse.
For some context, the following chart shows the spread of the UK bank rate over the fed funds rate over the last 12 months, as well as the spread of 10-year gilt yields over Treasuries. The Bank of England, hobbled by a more obviously troubled economy, slipped behind the Fed in the hiking cycle. Meanwhile, 10-year gilts continued to trade at a lower yield than Treasuries — until the morning of the mini-budget, when they overtook Treasuries in spectacular fashion:
It’s also inaccurate to say: “No, the pound isn’t crashing over a trifling batch of tax cuts. It’s because the markets are terrified of Starmer.” That was the headline on an article by Conservative peer Daniel Hannan published by the ConservativeHome.com website. Keir Starmer is the leader of the opposition Labour party, whose chances of coming to power in 2024 seem to have improved this week. Markets would doubtless prefer Britain not to move back to the center-left. Political uncertainty was a component in the loss of confidence. But the greatest problem was the appearance that the current government is incompetent, and that yet another leadership change lies ahead. In a week dominated by discussions of the gilt markets, I hadn’t seen or heard Starmer’s name mentioned even once until that article. The next general election is two years away, far too distant for markets to pay attention to Labour’s improvement in the polls.
When criticizing a politician, it’s difficult to avoid the appearance of making a political point. But the facts in this case are obvious. This was one of the biggest and most damaging market reactions to a policy announcement in memory. The error was entirely avoidable and self-inflicted, and its perpetrators have no choice but to own it.
More magazine covers. The Economist’s trajectory on the Liz Truss administration can be traced through its covers. This was three weeks ago:
And this is their current cover:
Is this just a matter of the elitists who read the Economist looking down on people with whom they disagree? No, not really. This is the front page of the Daily Star, one of Britain’s livelier downmarket tabloids, from earlier this week:
As for Bloomberg Opinion itself, it’s fair to say we pegged in advance that Liz Truss’s greatest risk was ridicule. This is the headline from a piece written three weeks ago by Sir Max Hastings (a former editor of the Daily Telegraph):
And this was the headline for Points of Return yesterday:
With the latest polls showing a spectacular fall in the Conservatives’ popularity, this looks like one occasion when the media managed to do more than provide contrarian indicators. And they might even have provided something like a laugh at a difficult time.
Have a good weekend everyone.
More From Bloomberg Opinion:
- Aaron Brown: The Stock Market Had History on Its Side.
Now It Doesn’t
- Clive Crook: Is It Too Late for Truss to
Repair the Damage?
- Javier Blas: Uncle Sam Wants to Be an Oil Trader.
That’s a Bad Idea
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