Federal Reserve Chairman Jerome Powell, keeper of the buck, speaks today. Should we care, investors and investor-relations folks?
There’s been less worshipfulness in the Powell Fed era than during the Yellen and Bernanke regimes. Out of sight, out of mind. We tend in the absence of devotion to monetarists to forget that the mighty buck is the world’s only reserve currency.
Yet the buck remains the most predictive – besides ModernIR Market Structure Sentiment™ – signal for market-direction. So we have to know what it’s signaling.
When we say the dollar is the reserve currency, we mean it’s proportionate underpinning for other currencies. Effectively, collateral. The European Central Bank owns bucks and will sell them to weaken the dollar and strengthen the euro, and vice versa.
The USA alone holds no foreign currency reserves as ballast to balance out the buck. Instead, if the Fed wants to hike rates, dollars have to become a little rarer, harder to find.
The Federal Reserve as we noted when oil dove has been selling securities off its balance sheet. It receives Federal Reserve Notes, bucks, in return, and that money comes out of circulation, and dollars nudge higher (forcing other central banks to sell dollars).
Combine what the Fed has sold and what banks are no longer leaving idle at the Fed as excess reserves (at the height $2.6 trillion but now below $1.8 trillion) and the supply of bucks has shrunk $1 trillion, and since banks can loan out about nine dollars for every one held in reserve, that’s a big decline out there – effectively, trillions.
So the dollar rises, and markets falter, and oil plunges. We wrote about this back in January and said to watch for a rising dollar (even as others were predicting $100 oil).
Now why do stocks and oil react to relative dollar-value? Because they are substitutes for each other. As famous value investor Ron Baron says, investors trade depreciating assets called dollars for appreciating ones called stocks.
If the dollar becomes stronger, you trade fewer of them for stocks. Or oil. That means lower prices for both. Conversely, when interest rates are as low as a doormat, credit creates surging quantities of dollars, and the prices of substitutes like stocks and oil rise.
It raises a point I hope future economics textbooks will recognize: The definition of inflation should be “low interest rates,” not higher prices. Low rates surge the supply of dollars via credit, so even if prices don’t rise everywhere, inflation exists, which we find out when rates rise and prices of things used as substitutes for dollars fall.
Those people saying “see, there’s no inflation” do not understand inflation. By the way, Exchange Traded Funds have exactly the same condition, and risk. They are substitutes for stocks that expand and contract to equalize supply and demand.
Presuming Chairman Powell wants interest rates higher so we can lower them furiously – and wrongly – in the next crisis, we can expect more deflation for things that substitute for dollars.
It won’t be linear. ModernIR Market Structure Sentiment™ signals a short-term bottom is near. There may be a rush to the upside for a bit. Credit will go to “strong sales expectations for the holiday season” when it’s likely market-makers for ETFs trading depreciated stocks for the right to create ETF shares. Like the buck, the stocks come out of circulation – causing stocks to rise – which in turn boosts ETF shares tracking those prices.
The problem as with currencies is that we can’t get a good view of supply or demand when the medium of exchange – money, ETF shares – keeps expanding and contracting to balance out supply and demand.
The market loses its capacity to serve as an economic or valuation barometer, just as money loses its capacity to store value.
I’ve said before to picture a teeter-totter. One side is supply, the other, demand. When currencies have fixed value, we know which thing is out of balance. When the fulcrum moves, we have no idea.
That distortion exists in stocks via ETFs and economies via the mighty buck, which both must buck mightily to equalize supply and demand. Who thought it was a good idea to equalize supply and demand? I hope Jerome Powell bucks the mighty.