By Max McKegg
Donald Trump has followed George W. Bush by slapping tariffs on key imports
US and Eurozone inflation is holding steady, for now
But tit for tat tariff increases by major economies could spark inflation
Rate differentials are currently firmly in favour of the US dollar
The spread between US and German two-year bond yields has hit a high of 2.8%
FX traders spent Thursday afternoon taking on board the implications of President Trump’s plan to introduce tariffs on steel and aluminium imports, including the potential for retaliation, initially by the European Union and China, and later other countries that will want to wait and see what the big boys do.
At the close of New York trading on Thursday, the USD index was down on the day, but not by much, as were bond yields. Stock market traders were more forthright in their response, sending the Dow down 600 points at one stage.
President George W. Bush introduced steel tariffs in 2002, on the back of tax cuts the previous year, so history might be a guide. The USD index declined sharply over 2001-2003 as shown in the chart below. The initial stage of that chart pattern has been repeating since early last year: the trend is your friend.
Some economists think a tit for tat tariff increase by the major economies could spark inflation. Maybe, but in the meantime the latest update on the Federal Reserve’s inflation benchmark – the price index of Personal Consumption Expenditures – matched expectations with the annual headline rate at 1.7% and core at 1.5%, both unchanged on the previous month.
The reading had little impact on financial markets: three rates hikes this year remain a high probability based on fed funds futures pricing. In the 2004, as the impact of the dollar decline showed up in consumer prices, the Fed funds level was moved up sharply to chase the inflation rate and eventually match it, as illustrated here.
Fed funds versus PCE chart
history repeat with USD continuing to track the 2001-2003 pattern,
eventually falling far enough to spark inflation? No one knows: movement
in medium term FX rates is just as hard to forecast as gyrations on
But there in another potential trigger for inflation, dormant for years, perhaps soon to be awakened.
When discussing the outlook for inflation and therefore interest rates we often see economists making reference to the “Phillip curve”, the relationship between the unemployment rate and wage growth. In theory, as the unemployment rate drops, wages rise. And, as shown in the chart below, that’s what happened in the past among the G7 economies as a group.
However in the period 2009-2017, as unemployment has fallen from close to 9%, wage growth has hardly budged. In economist jargon, the Phillips curve has flattened. The chart suggests there could be some catching up to do and a move anything like that indicated would be a game changer.
Phillips curve chart
Source: Capital Economics
Be that as it may, the latest wage growth readings from the major economies suggest there is no immediate prospect of an inflation surge. In the Eurozone, the flash estimate for the year ending February (one month ahead of the US update) showed headline and core inflation stuck in the doldrums at 1.3% and 1% respectively.
There's nothing encouraging in those numbers for the European Central Bank or, indeed for EURUSD bulls, who long for some fundamental justification for the current level of the pair, especially with the interest rate differential providing such a headwind.
spread between US and German two-year government bond yields has hit a
multi-decade high, and a couple of basis points could be the straw that
breaks the camel’s back. Photo: Shutterstock
As the following chart shows, the spread between US and German two-year government bond yields has blown out to a multi-decade high of 2.8%. Are we getting close to the stage when a couple of basis points could be the straw that breaks the camel’s back?
US versus German 2 years chart
Nevertheless, expanding rate differentials have been unable to prevent a decline in USD over recent months. But we could be close to a tipping point, and not just in EURUSD.
As this chart shows, the yield on 10-year US treasuries tops the G7 and is now pushing ahead of the traditional high-yielder like Australia and New Zealand. Rate differentials may be out of fashion among FX traders but they will reassert themselves when least expected.
World 10 years chart
Source: Wall Street Journal.
It would be a brave FX trader who tries to second guess what rate differential will be the last straw for EURUSD. Similarly when or if the Phillips curve comes into play and in which economy first.
With so many balls in the air, the best thing a trader can do is stick with the trend. For the USD index, if not necessarily for all its components, especially USDJPY, that trend is down.