Jackson Hole: How Will The USD React To Fed's Yellen Speech?
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Market attention will be squarely focused on US Fed Chair Yellen’s speech at the Federal Reserve Bank of Kansas City’s annual Economic Policy Symposium in Jackson Hole. We believe she may use the opportunity to signal the FOMC’s growing confidence in the outlook for activity and inflation, given the rebound in labor markets since June and the solid rise in household spending in Q2. Although some FOMC members have lingering concerns about inflation, we expect Yellen to deliver a stronger signal about the likelihood of nearterm rate hike and retain our view that the next increase will occur in September.
Given the low market expectations for a September or December Fed rate hike, a repricing at the front end of the rates curve in the event of a hawkish signal should drive a near-term rebound in the USD, accompanying a bear-flattening of the yield curve.
However, the reaction in the USD over the medium term might be complicated by the Fed’s seemingly increased comfort with a modest overshoot of the dual mandate. Recent communications by current and former Fed officials suggest that the FOMC is coming around to the point of view that potential growth has fallen, the Phillips curve is flat, and the neutral rate of interest has fallen to very low levels. If the Fed wants to test whether monetary policy can bolster rates of productivity growth, it could let the domestic economy ‘run hot’ as it evaluates whether productivity is rebounding. If so, incoming data on inflation could become incrementally more important for understanding the Fed’s reaction function. Our rates strategy team thinks that a shift in the reaction function is likely to allay market concerns of lower-for-longer inflation and lead to a pickup in term premia, driving a steepening of the US yield curve.
How will the USD react, given the shifting reaction of the Fed?
Figure 1 summarizes our findings of the dollar’s reaction to the different scenarios of the USD curve. Our results suggest that bear-flattening of the yield curve is unambiguously positive for the USD, implying that a near-term USD rally is likely if Yellen indeed signals a near-term hike, as we expect. However, the durability of this bear-flattening rally in the USD is questionable, given the shifting reaction function of the Fed, in our view, unless supported by evidence of accelerating wage-price inflation accompanying a tightening of the labour market. The performance of the USD in a bear-steepening environment is however mixed historically, although a steepening of the 5s30s curve – a scenario that our rates strategy team expects to materialize – is mildly negative for the USD. But an overshoot of inflation relative to policy rates could lead to more negative real yields in the USD, which could lessen the relative appeal of USD assets, ceteris paribus (eg, assuming real yields in trade partner countries stay stable).
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