Every time a crisis hits, you get a new round of people warning about the end of US dollar dominance. The Covid crisis and its aftermath is no exception. It may be that the world will change over the long run in some way that does help to dislodge the greenback. But in the meantime, concerns about a looming recession mean that the dollar is booming against other currencies. It’s at a 20-year high against the euro, and it’s soared against the yen as well. So why has the dollar been rising? And what is the impact of that on the world economy? On this episode, we speak with Jon Turek, the founder of JST Advisors, and the author of the Cheap Convexity Blog, about why the dollar’s been so strong, and the risk of a potential “doom loop” that will drag down the global economy. Transcripts have been lightly edited for clarity.
Points of interest in the pod:
Why is the US dollar so strong right now? — 05:28
How do higher commodities prices impact currencies? — 7:08
What does a stronger dollar mean for the ECB? — 11:04
Why haven’t capital inflows helped the euro more? — 15:31
Could the ECB hike rates and also buy bonds? — 19:07
Are we seeing the start of a reverse currency war? — 21:48
What does a strong dollar mean for the BOJ? — 27:49
What could break the dollar doom loop? — 33:53
Is high inflation all about Russia/Ukraine? — 40:58
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Tracy: (00:10)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:15)
Joe happy parity day to you.
Joe: (00:17)
So I looked, I actually got up a little late this morning.
Tracy: (00:22)
5:00 AM instead of 4:00 AM?
Joe: (00:24)
I don't think it did quite exactly hit a dollar. I saw some am ambiguity. It looked like the low on the terminal was like Euro 1 0 0 0 0 0 0 0 1 or something. Then I saw others posted. I don't know.
Tracy: (00:39)
It's sad that we work for a gigantic financial data company and we can't figure this out. I thought it did. I'm pretty sure it did very, very briefly. But let's just, you know, even if it hasn't actually hit parity today, -- we're recording this on July 12th -- It seems like it's going to any moment. And I gotta say the fact that we're recording this episode though, probably means that this is marking the peak, right?
Joe: (01:04)
Yeah. So of course, when this episode comes out, it's going to be the peak of the dollar because that's how it works. Nonetheless, yes. Euro has come very close to parity with the dollar, de facto parity. The dollar itself is just incredibly strong. It might even be, you know, obviously inflation and the trajectory of inflation is sort of this huge variable question for the economy. But in terms of like maybe the defining market story right now, it has just been this incredible strength, the US dollar, which totally has all kinds of different ramifications.
Tracy: (01:37)
Exactly. So setting aside what happens to the euro, you cannot argue with the fact that we have had this broad-based dollar strength. You know, there's some irony that, of course everyone's talking about the end of the world and we recorded episodes about how the Russia Ukraine conflict and the sanctions mean that the dollar is going to fall out of favor in the global financial system. And yet the immediate knee jerk reaction to the world falling apart is dollar strength. It almost always is.
Joe: (02:04)
Yeah. Right. Because in the end, in the good times, you never really have to pay your bills. You just sort of roll over your debt or you don't worry about that. Or you're flush with money in the bad times. You're like, oh, how am I going to pay my bills? I can't pay my bills probably in Bitcoin. I can't pay my bills in shares of Tesla. I can't pay my bills in, you know, shares of ARK or whatever. What I do need is dollars. And so everyone scrambles for dollars and they get more expensive.
Tracy: (02:29)
Right. So the dollar is basically a play on risk appetite at this point, but I guess the ultimate irony, this is the second time I brought up irony so far.
Joe: (02:38)
The ultimate ultimate.
Tracy: (02:38)
The ultimate ultimate irony is that when everyone's worried about the future of the economy, the dollar tends to strengthen and then the dollar strengthening actually has a negative impact on the global economy. And so you can get the situation where it becomes a self-fulfilling cycle. The dollar doom loop is what some people have called it.
Joe: (02:59)
Yeah. A feedback loop. And if you're Germany and you're already sort of moving from this huge current account surplus to a current account deficit, largely due to the surging price of energy. And then obviously everything becomes even more expensive now, especially things priced in dollars or invoiced in dollars. And so yeah, you can have this sort of doom loop where the strength of the dollar even further puts the squeeze on different players.
Tracy: (03:23)
Yep. So without further ado to talk about the doom loop and more broadly what's going on with the dollar and a bunch of other currencies, like the euro and the yen, we are going to be speaking with Jon Turek. He is of course, the founder of JST Advisors and the author of the Cheap Convexity blog. Jon, welcome to the show.
Jon: (03:43)
Thank you so much for having me.
Tracy: (03:45)
So I think the first time we had you on was actually to talk about exactly this dynamic, the dollar doom loop.
Jon: (03:51)
Yeah, it was. It was actually, I think in the beginning of 2020. The pandemic had just started and it was really the first time the Fed really fully unleashed its swap program in terms of foreign exchange. And I thought that the, you know, the doom loop was a very prevalent factor in kind of the 2010 cycle where we saw this slow down in the manufacturing side of the economy, largely on the fact of China's, you know, aggregate growth numbers starting to structurally fall, which, you know, as the US is less exposed to global trade global manufacturing, saw it become a relative beneficiary. And then given the dollar linkages through global trade and manufacturing, it only reinforced the weaknesses in manufacturing. So it seems like we're in a similar dynamic with different catalysts.
Joe: (04:45)
So before we even get into the dynamics, how would you describe, I mean, everyone is sort of waking up to this weird phenomenon, which is that after an era of so much stress and so much talk, you know, about the end of the dollar, it's going to be replaced by Bitcoin or China and Russia are going to like circumvent the dollar or something like, you know, every crisis [we have] this kind of talk.
Tracy: (05:07)
I am old enough to remember when the euro was going to replace the dollar.
Joe: (05:11)
Right. Gold. We’ve heard it [all], the Brics are going to like form some sort of new, like Deutche Mark, whatever. You know all the theories. If someone's like, okay, here's the dollar it's basically back at all-time highs and someone says, ‘Jon, why's the dollar so strong?’ What's your answer?
Jon: (05:28)
Well, I think that part of the reason this time is that it's a structural dynamic. You know, I think a lot of the 2010s, it was the US was the cleanest of the dirty shirts. And I think that this time the US is the most self-sufficient. And I think that is, I think, the relative dynamic at play this time, as opposed to last time when we were just broadly in a slowing nominal GDP world, where we had, you know, low levels of realized growth and the US was kind of growing just a bit faster. Now I think it is really a self sufficiency thing that I think is, you know, really been encapsulated by this energy crunch that we're seeing, especially in Europe.
Joe: (06:15)
You know, Tracy, and I'm thinking back to our last conversation from a few months ago with Zoltan Pozsar, and of course he has this whole framework of like, you know, Brenton Woods III, commodity centrality. And I did have that thought at the time, and I think it's on the episode, it's like, wait, isn’t the US also filled with tons and tons of commodities? If we are going to be entering this new commodity-oriented regime where whoever has the most stuff wins, the US is pretty good on that front too.
Tracy: (06:43)
Right. It's not the worst place to be. So Jon, maybe talk to us a little bit more about how energy factors into currencies, you know, the weakness in the euro, the strength and the dollar, if it all comes down to energy, could you maybe walk us through exactly how energy prices or an energy shortage actually feed into currency weakness or strength?
Jon: (07:08)
Yeah, of course. So, you know, I think that a good way to do this is also take a step back in the sense that a lot of currency movements, especially in the previous cycle, and I would even really argue until the Russian invasion, a lot of it was predicated on relative interest rates and kind of, you know, which central bank was a bit more hawkish, which was dovish. That was kind of usually the forward rate space was a big marginal factor in kind of, you know, which currencies would be best off. And I think, you know, really what changed now is that we're really in a terms of trade, trade balance, current account world, where the market in currencies space is really looking beyond, you know, which central bank is going to do the most, to where our trade balance is going to settle.
And given that energy now has a two-pronged effect on that, I think it really emboldens that to play a more determinant role in exchange rate prices. And I think, you know, getting into the role of energy, especially when it's this sort of crunch where, you know, we're talking about the potential of Russia, turning off gas flows into Europe, it really does have a two-pronged effect. One is that either the price of, you know, related fossil fuels or energy inputs goes up, which is something we've seen. Nat gas prices in Europe are very, very high. Power prices as a byproduct that have risen a lot. So the trade balance is getting hit on that. And then we have this factor where, because it is a crunch, Europe is not able, or at least projected to not be able to produce, as much as its capacity is.
So their exports by nature will fall relative to what they could have been because they don't have the energy inputs to facilitate it. So really in terms of thinking about the current account or the trade balance, more importantly, is it's really a double whammy because they're importing more energy inputs and they can't export as many outputs. And as we've started to see with the Northern European trade balance, you know, Germany after 20 years of running significant, significant trade surpluses is now running a pretty significant trade deficit. And I think that is why this factor is so, so important because it really hits on both fronts.
Joe: (09:35)
So I have two quick questions, one short, and one's a little bit more [involved], but the first one real quickly have we actually seen exports start to weaken in Germany, because I know obviously the import bill has surged and we know a lot of industrial players have said like, ‘look, we can't just, we can't work economically with these high gas prices.’ But have we actually seen that in the data where the exports start to turn down?
Jon: (09:57)
So exports haven't started to fall meaningfully yet, but we have already seen the imbalance grow between the import side and the export side by nature of, you know, the trade deficit. And we've already started to see at least in, you know, the PMI data on the manufacturing side, that there will be slowdowns. It's just not economical for a lot of the heavy industry players at these prices.
Joe: (10:21)
And then my related question is in a situation like this, where there is a true crunch that, you know, the energy bill is soaring, but also you have domestic weakness because you just can't even maybe run these factories at these level of power prices, does that make it essentially harder for the ECB to fight inflation? Because here, I guess look, the US economy is hot, right? Or at least it has been up until very recently. So it's sort of like a very natural thing for the Fed to want to hike rates and tap the brakes and try to diminish demand. It doesn't seem like the ECB has that luxury.
Jon: (11:04)
Yeah. So the ECB is really in a proper bind here. And I think it really boils down to two problems. One is even taking, I think more meta structurally, even looking beyond this shock in its specific nature is that the ECB was already faced with a problem of you have central banks around the world who are aggressively responding to much above target inflation and the threat of higher inflation expectations. And the ECB was going to have to play catch up in some capacity. And we've already started to see that pivot over the course of year. We know they'll hike at their meeting next week and they'll hike again in September and kind of commence a hiking cycle. But the problem we started to see as more hikes got priced into the European curve is that it started to create stresses in the periphery where we had an uneven transmission of policy as spreads between, you know, Italy and Germany, and really the periphery and the core, started to blow out.
And this was really emblematic of the structural imbalance that is sort of innate to the euro area where we started to see the world of potentially you could have a rate that is not high enough to fight inflation and too high for the periphery. And this led to the forthcoming ECB meeting we’ll be sort of introduced to an anti-fragmentation tool. We've seen that the ECB has already started flexibly reinvesting their PEPP purchase portfolio. It's kind of a way to alleviate these issues in spreads, but it nonetheless, is still a big issue. And before all of the gas-related energy crunch issues, we were already entering a world where rates weren't getting high enough to cut off imported inflation by currency weakness, and they were getting too high for some of the peripheral holders, namely Italy. So that is one side of the ECB challenges, which is already pretty drastic.
The other side is the nature of this shock is innately very stagflationary in the sense that it raises the cost of energy by a lot. And it also reduces output by there actually isn't enough, or there'll have to be some sort of reallocation of resources, right? If the decision becomes, you know, making sure that everyone's heat stays on in the winter or turning off one or two factories, the decision is going to be pretty easy for policymakers, as unfortunate as it is. That is the second fold of it, where now we have a shock that really worsens the inflationary pressure in Europe, but also further reduces the growth impulse and on the output side, all in the backdrop of an imbalance that the ECB is fighting, that is almost innate to their monetary design, which is, you know, common currency union, no common fiscal.
So it's going to be an extremely challenging task for the ECB. I think, you know, at the forthcoming meeting, it'll be interesting as we begin to outline, you know, the ECB has taken a stand that growth is still good and, you know, nominal growth and especially on the consumption side in Europe is still pretty good. But we know that once the industrial side, especially in the core and Germany, becomes uncompetitive, then the economic spillovers are going to be pretty significant. And we could be looking at, you know, for the second time in the last two ECB hiking cycles where the ECB is hiking into a recession and you know, how the ECB kind of structures, you know, their inflation fight in the context of a material growth slow down is going to be very interesting. And I think the currency right now is proving to be an on top of all of these factors, proving to be an outlet for that unknown.
Tracy: (14:58)
What happens to capital flows or capital inflows when the ECB starts hiking? Because one of the weird things about what we've seen so far this year is that even with all the challenges that Europe faces at the moment, I think they've still had net inflows into the euro zone. And you would expect if the ECB hikes rates that that would make them more attractive compared to some other yields on offer, but like even if inflows have been positive, it doesn't seem to have had much of an effect on the euro?
Jon: (15:31)
Yeah, it's an interesting one because this year was supposed to be, and I think if we scrolled back to the last time I was on going into our 2022 preview, this year was kind of supposed to be a very positive euro currency story, in the sense the potential of the end of negative interest rates was going to spur this return of, you know, longer-term stickier capital, either through reserve managers, pension funds, etc., that kind of became, you know, priced out by a negative rates. And, you know, so the story of APP and NIRP in Europe is very much this one of, you know, starting from 2014 on, it was basically this replacement of ownership between a lot of foreign owners who own budns, BTPs in Italy and French government bonds. And it was basically replaced by the ECB.
So the currency channel, we had what’s called portfolio, the portfolio channel was really in full effect. And there was some thought that we could trigger the inverse by leaving negative rates. And I think we really did start to see that, especially after February ECB, when it became clear that, you know, negative rates were probably going to end this year, I think it was a trigger. There were nominal yielding securities in the euro area that were compelling, that hadn't been for eight years almost. And I think that was a spur for capital. I think the problem now is as the ECB fights this, is we really don't know what it’s going to look like? And kind of in the choices of bad choices, which bad choice do they lean on?
And I think the thing that you know, is probably worth watching the most is that if there really is rationing and some of the industrial activity has to go offline is there's going to be a fiscal response, right? I don't think we, none of US really assume that, you know, the fiscal authorities are going to just let companies default or people be laid off because their factory can't run because they don't have the proper inputs. There is going to be a response. And then the question is, you know, especially in the context of an already [existing] problem in Italy in terms of periphery spreads, is how does the ECB respond? And, you know, I think we are setting up for the potential, I wouldn't, you know, bet everything on this, but you could envision a world where the ECB is actually net buying securities again, while they're hiking things.
And this is something that, you know, Trichet actually talked about on a Bloomberg interview not too long ago. And, you know, I wouldn't say it as a base case, but given how the energy crunch could turn into a liquidity crunch at the same time that, you know, Italy is facing a problem with, you know, rising European rates, it's not impossible to start to think about, you know, kind of what does the ECB balance sheet approach look like in that context? And I don't think it's one of, you know, significant contraction, even though they are tightening policy to deal with above target inflation.
Joe: (18:34)
If the ECB is expanding its balance sheet in order to maintain or constrain Italian spreads, while at the same time hiking rates in order to fight inflation, that seems like one of those things where it's like, yeah, a bunch of people are going to dunk on that on Twitter and it's like, ‘oh, those look at those ECB folks. They don't know what they're doing. They're trying to fight inflation, but expanding the balance sheet,’ but setting aside Twitter dunks, it's not necessarily economically unsound, right? Like you could do both at the same time. It's not necessarily contradictory.
Jon: (19:07)
It is not necessarily contradictory. It will be in a relative sense because we'll be in a world where every other central bank outside of the Bank of Japan is withdrawing liquidity. So it would be in that sense. And I think the currency message would be confusing, but I personally think, and, you know, I don't know how relevant this is, but I think the ECB did make a mistake in terms of linking APP at their QE program to rates the same way that every other central bank had. Only because we know that, for the BOE or for the Fed, that they've kind of outlined QE as sort of this almost forward guidance tool, which, you know, when it exists, we know that they can't hike rates and the linkage between QE and rates actually enhances the net easing effect. And I think the ECB wanted to do this, which was basically kind of set up these guardrails for the market to price and hikes via the balance sheet.
The problem is, is that as we're sort of seeing, especially in periods of wide economic variance, is that QE is probably a more structural dynamic to Europe given the innate imbalances of the union, than it is, let's say, in the US or in the UK or in, you know, really any other developed country. So I think that is something that will probably become more talked about as we get to the end of the year. And Europe is in this, you know, kind of nasty stagflationary world is, you know, what is the role of QE even in a hiking cycle, especially as the ECB is never going to be able to kind of have a quote unquote ‘QT’ episode where the stock of liquidity would also basically fall, not only the flow, but no, I think it would be, you know, on the day, if it were to be announced, I think you would further amplify currency weakness just as a byproduct as they would be the only ones injecting liquidity at the same time that everyone else is withdrawing it. And as we move forward on, I think it could become just a more institutionalized part of how the ECB conducts monetary policy is that, you know, there is sort of this like net sticky buying of government bonds, even that is agnostic for the policy cycle.
Tracy: (21:48)
So you mentioned something striking, which is the idea of a lot of the major central banks, you know, being in tightening mode all at once. And we've had previous situations where the major central banks have been in loosening mode all at once. And they've been, you know, launching their own QE programs and things like that, and lowering interest rates all at the same time. And in that environment, people used to worry about competitive currency devaluations and a sort of race to the bottom. With more people tightening, do you worry about currencies going up? Like a competitive valuation? That seems kind of weird. I guess what I'm asking is what is the impact of all these people trying to raise rates at the same time?
Jon: (22:33)
Yeah, it's a great question. And I think it only has added importance given that many of the world central banks right now are fighting imported inflation much more so than excess demand. We do have cases like the UK and the US where there were some signs of overheating or excess demand, but, you know, taking the Europe example and something that I think Lagarde has been quick to point out, but even more so the chief economist Philip Lane, is this idea that, you know, real output has not exceeded its pre-pandemic level in Europe yet. It doesn't mean that this hasn't been as strong recovery. It has. We know that unemployment is the lowest it's ever been in Europe. There's signs that, you know, wage gains are picking up. It has been a strong recovery from Covid, but it's not just purely a ‘there is too much demand’ story.
There is an imported inflation, terms of trade shock that has clearly amplified the inflationary dynamics that we've seen. And in that world, the biggest help in terms of tightening policy is the currency, because that's sort of how you neuter the imported inflationary dynamics. This is something that we've seen China do actually relatively well over the last call it year, is be able to kind of neutralize the imported inflationary dynamics from energy, commodities, food, etc., by having a stable, strong currency basket, you know, the renminbi against the currency basket that they track. And I think, you know, we're in a world now where central banks who are all dealing with above target inflation have very little tolerance for massive currency weakness because it's thought to only amplify the pressures that they're dealing with by hiking rates. And this is something we've seen pretty much across the board.
We've seen the SNB in Switzerland hike rates 50 basis points at the first meeting, they surprised the market. And part of their calculus is that even though the Swiss franc has been strong, it hasn't been strong enough in real terms to kind of offset some of the above target inflation that even they're seeing. We've seen kind of a little bit of a pivot from the Bank of England who originally had, was kind of the first central bank to entertain the idea that a growth scare should also be part of their kind of calculus in resetting policy. But we've seen from, you know, external MPC member, Catherine Mann, put out as speech about the idea that, you know, if we're not keeping track with the Fed, then we're going to be, you know, we're going to further exchange rate pressures, which is going to further the import of inflation dynamics that we're dealing with already.
And we've seen kind of, you know, more people on the BOE entertain this idea that, you know, the exchange pass through is amplified right now, especially as we're in this kind of bind. And in terms of where inflation expectations, are they moving away from target. And we've seen that central banks have sort of taken a risk management approach to that, where if there is in doubt that they're kind of in threat at all, then they're going to act. So I do think, you know, I don't know that, it's a reverse currency war in a way, but I do think you have central banks around the world saying that, you know, our currencies have weakened and that has only amplified the pressure that we're facing because a lot of the nature of the shock is imported by the commodity side. So I do think we are in that sort of world.
And to further this, we've seen central banks that have relied on currency strength as a way to almost not hike interest rates, hike interest rates this cycle because the currency is either weakening are not doing enough. We've seen Switzerland hike. We've seen the Bank of Israel hike. We've seen Taiwan hike, and these are central banks [who] last cycle were able to weather sort of, you know, participating in hiking cycles via just having a very strong, nominal, effective exchange rate. And this cycle we're seeing there's a difference between your NEER and your REER, which is your real effective exchange rate. And they don't move automatically one for one in a very high inflation environment. So I do think we are in this sort of, you know, reverse currency war, but I think that central banks are clearly making an emphasis on the role of currency, some more explicit than others, of course. But I do think given the nature of the shock, it does make sense for central banks to have a very big, you know, overarching currency focus.
Joe: (26:55)
We need to do like a series of just Jon with like all these niche central banks or these smaller ones. Bank of Israel day, Swiss National Nank day, Taiwanese central bank, that would be, you know, of course we would need to have a whole week just devoted to Australia and New Zealand because they tend to be bellwethers. That being said, I wanna pivot a little bit to Japan where we see dollar/yen basically at its highest level since 1998. My understanding [is], I don't think the Bank of Japan has pivoted in any way, like some of these other major central banks in terms of easing, I think they're still doing yield curve control, the yield on the 10-year Japanese government bond is still like, you know, 0.25 or something super low. What's going on there? I seem to recall something too where like last month the market thought it was going to try testing the BOJ in some way. And the JGB futures got out of hand a little bit, but what's going on there?
Jon: (27:49)
Yeah. So I mean the last BOJ meeting in June, we really had a real earnest test of BOJ's resolve in terms of fighting ,where we saw 10-year swap rates in Japan move a lot further away from where the, you know, 10-year equivalent JGB yield is, which is, you know, enforced by the BOJ. We saw the same thing in futures. And it was kind of this idea that, you know, once dollar/yen gets above 130, gets to 135, you know, maybe they don't drop yield curve control, but maybe they readjust the band. Maybe they go from, you know, targeting 25 basis points to 50 basis points. Maybe they move YCC to the five year instead of the ten year. And the market was really, you know, kind of wrestling with this, you know, how do they adjust? Because certainly they're not okay with kind of this further rapid depreciation in the yen, especially as Japan, like everyone else, maybe to a lesser extent, is dealing with an energy shock and you know, higher levels of spot inflation domestically, etc.
Joe: (28:49)
It’s funny, I'm looking at the Bloomberg and Japan's inflation is its highest in multiple years, but it’s only 2.5% on the headline.
Jon: (28:56)
Two and half.
Joe: (28:57)
That's a big change. For anyone that grew up in Japan. That's a big change.
Jon: (29:02)
Right, right. And you know, I think so where the BOJ is and I think their stubbornness has surprised a lot of people, but I actually think they've been pretty, you know, consistent with their reaction function. And their idea is that they're not going to jump on this bandwagon of, you know, global tightening of policy in the context of something that they think is only a one-year phenomenon because what's idiosyncratic to Japan as well, is that a big part of the above target inflation we're seeing this year is not only from the energy side, it's also from mobile phone prices, which has kind of had this mechanical upward pressure on prices that will kind of come out next year.
Joe: (29:43)
So they're committed, so they're still team transitory in Japan?
Jon: (29:47)
They're still team transitory in Japan. I think the thing that would change them from being team transitory is something that Kuroda has really emphasized is that the medium term forecast for inflation has to move closer to 2%. Maybe that would be the catalyst for a change because as we've seen is the BOJ has sort of operated in this well, inflation is at 2% right now, or it's going to be above 2% for this year. But if you look at kind of, the last bank view meeting we had, which is where the BOJ publishes their economic forecast, was in April. And looking back at that meeting, they had 2023 inflation between 1.1, 1.3% for ‘23 and then ‘24, you know, somewhere around that range. And the BOJ has contextualized their reaction function as that prices need to be going to 2% in a stable manner.
And, you know, 1.1% inflation next year would not be considered stable. So what that has meant in terms of them setting policy, is that not only is it do not, don't move YCC, continue to let these like currency pressures manifest between widening interest rates. But also if you look at the Bank of Japan’s statement, it still has an easing bias. And we've even heard from Kuroda over the last few days where he's talked about, you know, the BOJ could be willing to do more, which I just think really like encapsulates how all-in they are, as in this is going to be, you know, some sort of procyclical reflation that is BOJ endorsed because not only is it, do they not wanna marginally tighten. It's they actually still have their full easing posture in terms of forward guidance. So I think that, you know, in terms of thinking about the BOJ and especially as it relates to the currency, I think really this whole year we've been in this inconsistency between what the market-implied pain point is for the BOJ and what the BOJ keeps telling you their pain point is.
And they've continued to say implicitly effectively that there's still plenty of room to go on getting resetting inflation, inflation expectations higher. And I think, you know, the thing to look for now is less of a ‘well dollar/yen goes to 140, so they'll definitely move.’ And I think this has kind of become amplified by the fact that the politics in Japan have become less favorable to a very weak yen policy. But I think the thing to look for now is as we actually, this month, we'll get a new, fresh forecast of, you know, more medium-term inflation in Japan. And I think that would be the catalyst to maybe a rethink, especially as energy pressures have only increased a lot since April. Currency has weakened a lot. It's very plausible to think that that the medium-term inflation projections are starting to move higher and as they do, I think the kind of wrinkle will be is the BOJ is not the Fed — they're not the ECB, they're not the Bank of England. They don't promise to be overly transparent — is that YCC starts to move in a kind of non-announced way.
So I think that is kind of the thing to sort of look out for, I think for now we're in this world where the BOJ is still max easy because they haven't seen the things that they've told you or told us that they want to see to trigger some form of marginally tighter monetary policy. And they're dealing — as much of the developed world is — is with this massive trade shock in terms of deteriorating terms of trade and worsening trade balance. So it's kind of been this double whammy. And I don't think that, you know, gets arrested immediately, but I do think the thing to watch in terms of YCC is as we'll see in July and we'll see again in October, I believe, is kind of this medium-term inflation forecast. That would be kind of more the catalyst to change course.
Tracy: (33:53)
In the intro, Joe and I were talking about the doom loop and this idea that it sort of becomes a self-reinforcing cycle because people worry about global growth and that sends the dollar higher and then the higher dollar implies slower global growth. And so you get this never ending cycle. What in your opinion is most likely to break that loop in the current scenario?
Jon: (34:19)
It's a good question. So I think, you know, what we saw in the 2010s is there was really two circuit breakers to the dollar doom loop. One is, you know, a massive Chinese credit easing that had global macro and economic spillovers by just increased global aggregate demand. The other was a dovish pivot from the Fed and the pivot from the Fed is something we saw a few times in the 2010s, we saw it at the end of 2018. We saw it in January, 2016 after hiking once, and the dollar kind of went nuts and, you know, commodity prices started to fall. Manufacturing started to fall. The Fed after that said, you know, we're not going to be hiking as much in ‘16, as we said we were going to be in ‘15. I think that has also been a catalyst this time. What makes this version of the doom loop really scary is it's kind of hard to see how those circuit breakers play out over the near term where, you know, we're now in this world of, we have a European problem, which creates pressure on the euro, which sends the dollar higher, which worsens the manufacturing cycle, which does this whole thing again. But is the Fed going to pivot with spot inflation at an eight handle?
We’ve seen that China has already started a pretty significant credit using. We've saw M2 numbers this week, which were high. We've started to see new loans beat, but we also are going to be very cautious and almost doubtful of some sort of Chinese credit expansion when we don't really get the pass through in the context of Covid Zero. So, you know, it seems a little bit like a broken transmission mechanism, at least in the context of the current economic constraints. So it's very, I think that is kind of the dynamic we're in now, where it's a little hard to see what kind of stops this. And I guess the best answer is that it could stop itself. And I think, you know, something to start to think about as we get, especially past September FOMC and really into the end of the year, depending on how, you know, bad the growth conditions are, especially in Europe, is that will the Fed sort of be able to do this implicit handoff from interest rates to global economic conditions, foreign exchange, you know, general FCIs, where, you know, I think something that's possible to me and something I've started thinking about, you know, talking to clients [about], is that the Fed may be able to hand off, in a sense, to the dollar.
And it's not this idea that the Fed would stop hiking or would be easing immediately, but sort of this idea that the Fed can start to slow down maybe in November, as we get like a few more consistent readings of lower core PCE or point threes on Core PCE. And, you know, the Fed can be able to point to ‘look at what the dollar is doing. Look at what financial markets are doing.’ And basically the Fed can net effectively tighten by staying still, given the context they're in. And I think this is like an interesting dynamic that could possibly start to curtail some of these pressures, but it, you know, I think until we get there, we're still in this bind of, you know, these are big disinflationary forces that the Fed is cheerleading at the moment, right? The thing that we saw last cycle is the Fed wanted to prevent them because it was always a financial conditions tightener that was more than what monetary policy setting warranted, where even in 2018 where the Fed was on a, you know, a quote unquote ‘path to neutral’ is it always ended up being tighter than they thought. And this was obviously the case in 2016 when they only had hiked once in December ‘15.
Where now the Fed is telling us they want to be restrictive. They want to get to restrictive expeditiously. And this is sort of a mechanism that amplifies the outcomes they're trying to engineer. I think it's very hard to see sort of, you know, what the offramp is in sort of an endogenous sense. I mean, the obvious, you know, other off ramp is sort of some sort of resolution in Ukraine and that, you know, I don't have any good insights into, but it'll also become a byproduct, you know, of how much pain Europe is willing to take.
I would assume, you know, I think that is kind of what makes this version of the doom loop so challenging is that it is a condition or an externality that the Fed in its efforts to lower inflation and lower inflation quickly is actually accentuating what I think is almost in their view positive. The question I think that, you know, market participants should begin to ask is if the dollar is doing all this work, you know, does the Fed have to go to 4.5% or something like that? I think that is an interesting question on its own, but in terms of like what arrests this current dynamic it's really tricky.
Joe: (39:31)
We have seen this pretty significant decrease in commodity prices over the last month and granted commodity prices aren't CPI, but they feed through. There are signs of this disinflationary impulses, gasoline prices, have been rolling over, other commodity prices. Some food commodities are way down. Is it possible that inflation actually meaningfully starts to surprise on the downside? Like, is there any prospect of that?
Jon: (40:01)
Yeah, I do think so. I think that, you know, it'll be very tricky to, I think get meaningfully lower prints in some of the stickier stuff on the services side. Yeah. Where, especially in the US, we'll be dealing with headwinds from shelter for a while, where I think it'll be tricky to kind of get back into the, you know, high twos on inflation. But I do think that, you know, and something that markets are pretty clearly starting to suggest is that we're on a path back to, you know, still maybe elevated inflation, but certainly nowhere near the levels we are now. And I think the dollar has clearly been a big part of reinforcing that mechanism between the exchange rate and things like, you know, breakevens or the market’s implied inflation rates. Because I think the nexus of all of that is that the dollar has started to get to a level which has really started to hurt commodity prices, even though we haven't seen any alleviations per se on the supply side.
Joe: (40:58)
And then my final question is, and you mentioned, you know, when we talked at the start of the year or the end of last year, you know, there was hope it might have been a good year for Europe and the positive benefit to the end of Nirp, etc., but the big thing that we certainly did not talk about at the end of last year and which most economists were not thinking about is the possibility of the war in Ukraine and the effect that that would have on commodities. And so, how much of this whole discussion that we're having, and, you know, we sort of talked tongue in cheek about a team transitory and everyone abandoned that last year, like how much does so much of the surprise to market [is] really just a function of this thing that happened that did not have to do with anything that at least economists were equipped to be predicting at the end of last year, at the very beginning of 2022?
Jon: (41:45)
Yeah. I mean, I think it's led to the stickiness, partly. I think it's more amplified to severity. You know, I think that something we've seen, you know, in the US, we've had more evidence that, you know, there's a large part of the inflation that overshoot is non-energy, especially as energy costs are so much lower than they are in Europe. But even in Europe, we've seen in like Christine Lagarde’s, you know, talk at Sintra that, you know, four fifths of their core basket is running above 2%. We've seen the Bank of England say, you know, something similar — that 80% of their core basket is running above I think, two and a half. So I think that we were in a higher nominal GDP world with inflation being a big part of that to begin with. I think that probably what has contributed to further central bank fears about inflation expectations and very elevated readings of headline inflation has been the Russia Ukraine war. But I think that we were in a probably higher inflationary regime than we realized call it December of 2021, that was probably going to be persistent regardless.
Joe: (43:00)
Jon Turek, thank you so much for coming on Odd Lots. Always impressed by both your ability to explain all these things, but also your breadth, you know, keeping tabs on what the Bank of Israel is up to is very helpful. So thank you so much, always a blast.
Jon: (43:17)
Thank you so much, guys. Really appreciate it.
Tracy: (43:34)
So, Joe, I guess, two things jumped out at me there. One is the US is in a relatively good place. Dollar privilege strikes once again.
Joe: (43:44)
But also commodity privilege
Tracy: (43:46)
And commodity privilege. But two Europe just sounds like it's in a whole lot of trouble.
Joe: (43:52)
Right? Yes. The double whammy on Germany is really striking. So the import bill’s soaring, and then if you can't even operate parts of your economy because they're dependent on this one specific input — gas at a certain price — that's brutal.
Tracy: (44:08)
Right. And it also feels like, you know, Japan, the BOJ could sort of face off against speculators last month and they were somewhat successful in doing that. But the ECB facing that particular inflationary backdrop, it just feels like there's no possibility that they're going to be able to jawbone the market in any way.
Joe: (44:27)
No. And then, you know, on top of the sort of double whammy to the core of how Europe’s industry works, you have the spreads problem. And that's because of the nature of European, you know, Euro area architecture and having to contain Italian spreads, which might mean expanding the balance sheet at a time when it's fighting inflation. That's tricky. That's a tough job for the ECB.
Tracy: (44:49)
Yeah. I feel like this always comes up when we talk about central banks, but like I do not envy central bankers and what they have to do right now.
Joe: (44:57)
I don't know. I mean, in Japan, it's just like we're setting the yield, we're setting rates at this. You could just go on vacation. We're setting 10-year rates.
Tracy: (45:04)
Well that's different. Okay, wait, if you were going to be head of any central bank in the world right now, which one would you choose?
Joe: (45:11)
I think I would choose Japan. Because it really does seem like they could say like, you know what? And as, as Jon pointed out, they don't have the same commitment to transparency as others have moved towards. It’s just like, you know, we're setting this at zero. We're going to take off for a while. We'll be back in a few months. Maybe we'll check in. That's how I would do it.
Tracy: (45:28)
Yeah. 2.5% inflation looks good in any other country.
Joe: (45:31)
Yeah. 2.5.
Tracy: (45:33)
It's basically the target in the US. All right. Shall we leave it there?
Joe: (45:37)
Let's leave it there.
You can follow Jon Turek on Twitter at @jturek18.