Yesterday, markets see-sawed while Powell was speaking at the Economic Club in Washington. Risk appetite fluctuated, and the dollar shifted. Less noticed, but perhaps more indicative of the longer-term trends for the dollar and other currency markets, was a steepening of the yield curve. That contributed to supporting commodities and their respective currencies.
How much the market moved just on a few comments by the head of the Fed goes to show just how much of the market’s dynamic depends on monetary policy expectations over economic outlook. In fact, the major driver of dollar strength or weakness isn’t around whether or not the US will enter a recession. It’s about how the Fed would react in a potential recessionary scenario.
The two roads for the dollar
The Fed insists that the US will avoid a full blown recession, or a “hard landing”. Powell admits that there will be “pain”, but has argued that at least technically the US will continue to grow. Analysts (and particularly politicians) can argue whether or not growth would be slow enough to qualify as “stagnation”. But the bottom line is that unless there is a recession, the Fed won’t lower rates.
The market is on tenterhooks not about the recession, but whether the recession will be bad enough to cause the Fed to “pivot”. That is, start cutting rates, lowering the cost of money, and allowing for a surge into stocks. This expectation would lead to a weakened dollar, as bond yields would fall.
Good news is bad news
The initial reaction to the latest jobs numbers was in line with that kind of thinking: If employers are hiring, it means there is less expectation of a recession. Which means the Fed has plenty of room to keep fighting inflation. That implies a weaker stock market even if the economy is doing better. In fact, because the economy is expected to do better, the stock market would underperform. But, the dollar would get stronger.
When Powell gave his remarks at the Economic Club, he basically repeated the lines given after the Fed decision. The market initially took this as a bullish sign (and the dollar weakened) because it implied that Powell was essentially saying that the latest jobs numbers hadn’t affected the Fed’s rate outlook, which is seen leveling out in the near term.
The change in outlook
When pressed specifically on the jobs numbers, Powell did admit that if inflation remained high, or if there were more jobs reports in a similar vein, then the Fed would likely keep hiking. Which shouldn’t be all that surprising to the markets, since that’s the basic assumption about the Fed. The issue is that Powell said the data affirmed the notion that there was still a long way to go to beat inflation. While that didn’t change the expectations for the rate hike trajectory, the market apparently interpreted it as a sign that the Fed could keep rates higher for longer.
That helped shift the yield curve, with the short end falling slightly while the long end rose. This “steepening” reverted some of the inversion (the curve is still inverted), and gave the dollar a boost. Because, essentially, the market priced in a lower chance of the Fed cutting rates in the near future.