The Fed notices the dollar

Well, that was an interesting set of Fed minutes, in much the same way that colon exams are interesting to their unhappy recipients.  For many market participants, Macro Man would venture to guess, the outcome was a series of intense if not not pleasant sensations.

Your author doesn't intend to engage in a thorough exegesis of the minutes, but there were a number of points which struck him.  The shot which hit the market's bow was, of course, the explicit reference to the dollar, and how it might impact both America's external accounts (X-M in GDP accounting) and, of course, the all-important 2% target for the core PCE deflator.  We can leave aside comments that the inflation target is really nonsensical- the average for the decade before the crisis was 1.75%, for example- and instead focus on why the Fed chose to raise the issue.

The Fed cited the euro, yen and sterling as weakening against the dollar.  Hmmm...let's see....the ECB had just announced an asset purchase program, speculation was mounting that the BOJ would add to its own QQE program, and the Fed meeting took place the day before the Scottish referendum, thus putting a significant risk premium on sterling.  More broadly, even in the absence of idiosyncratic factors elsewhere (the same sort of idiosyncratic factors, it need not be said, that provided a US tailwind via a weakening dollar for much of the Fed's QE adventures), does it really come as a surprise that the dollar might strengthen as the Fed starts to contemplate its first tightening in nearly a decade?  Really?

Perhaps Macro Man's reading too much into this, but it looks like one of those cases where those PhD models that assume "all else being equal" might have allowed its range of adjustable factors to be a little too narrow.  Either that or, as Yellen herself suggested, the Fed might be able to learn something from markets.   Sadly, if the recent dollar rally came as any sort of surprise, the FOMC might have to start with the basics- defining "mine", "yours", etc., because it would appear they have a LOT to learn.

Moreover, thanks to the shale revolution and the generally well-behaved consumer, it's not exactly like the US trade deficit is at all threatening.   Indeed, the current deficit is narrower in nominal dollars than it was a decade ago, and doesn't appear to be going anywhere.  (Admittedly, it's much too early for the recent dollar strength to impact the data.)  In any case, it's not like a stronger dollar is full of unalloyed negatives.   Lower commodity prices deliver a tasty positive income shock to households, which could spur a bit of  the spending that has thus far been fairly tepid in the expansion.

As for the DXY, it does look like the biggest flamingo in macro space currently.  It's easy to forget how neat the euro down-trade was; it could easily retrace back towards 1.30 while keeping the trend very much intact.

Another interesting feature of the minutes is that while they one again played the "stretched stock valuation" card, on balance the financial stability issue was pooh-poohed while the beneficent impact upon household balance sheets was pimped.  (OK, maybe not pimped, but at least mentioned.)  The Fed of course cannot say that they are targeting Spooz,  but it seems safe to assume that Yellen doesn't complain when they rip.

As for Macro Man, he still sees them in something of a no-man's land and frankly uninteresting at this juncture.  This is particularly the case given the forthcoming earnings season.

Finally, Macro Man was interested to read a couple of points which were roundly ignored by the market.  The first is that the minutes again noted that market pricing was quite a bit different from the dots (even more so now!) , ascribing this to pricing a element of a downside tail risk premium from a normal baseline.   This is probably somewhat accurate, though market pricing also likely reflects a "can Yellen actually look at herself in the mirror and hike" risk premium, given the extent to which she accentuates the negative.

What was also interesting is that several participants also suggested that current forward guidance gave the market a false sense of (dovish) security vis-a-vis the timing and magnitude of eventual rate hikes.   Just the other day, Dudley reiterated that a mid-2015 liftoff point seemed sensible...and yet EDM5 has rallied more than 10 ticks in two days!  Macro Man's favourite contract, Z5, rallied nearly 20 ticks peak-to-trough over the same period.

Yes, the minutes raised the USD and weak domestic demand elsewhere as "new" (ahem) potential negatives, and as such were correctly interpreted as dovish.  But they weren't unambiguously so- certainly not, in your author's opinion, to push Z5 from close to the bottom of its range to close to its top in two days.

Macro Man's had good success this summer playing the range in this contract, and it looks like it might be time to start contemplating another portfolio adjustment.

In the meantime, if the Fed really wants to "learn from markets" about arcane things like why hawkishly divergent monetary policy vis-a-vis the rest of the world might support the dollar, they should drop your author a line.  He's got some free time and could use a nice fat consulting contract.  And hey..it would put a dent in the unemployment gap......