The global macro divergences driving the dollar up highlight economic weakness outside the US that may be structural, not just the fact that the U.S. is leading the rest of the developed world’s recovery from the global financial crisis on a cyclical basis. If structural in nature, the need for easier monetary policy globally may last for years, in which case the dollar’s recent strength will be sticky, and the headwinds that poses to growth will linger. To the extent that the global growth outlook remains uncertain, a stronger U.S. dollar constrains the Fed’s ability to raise interest rates.
The Fed trapped itself in a policy feedback loop at the September meeting when the FOMC postponed the first rate hike and ostensibly linking future policy decisions to financial market stability. The Fed’s policy decisions are directly tied to global macro dynamics, not just the US economy’s idiosyncratic performance, since global factors influence US financial conditions. A more hawkish monetary policy narrative fuels dollar strength and equity and credit market weakness, which together constitute tighter financial conditions, raising downside risks to the US growth and inflation outlook, then prompting the Fed to soften its hawkish narrative. This triggers a rebound in markets which by definition eases financial conditions again, paving the way for the Fed to restart the countdown to rate liftoff; markets riot again, and the loop recirculates. This feedback mechanism exists because of the perception that easy Fed policy is the only variable sustaining financial markets in a growth and income-starved world.
An improvement in global growth is a prerequisite for severing the Fed’s dollar-feedback loop. Better global growth would trigger an improvement in non-US asset market sentiment and ease global financial conditions by spawning a durable rally in global equity and credit markets. This would weaken the dollar as capital flowed back into non-US markets, and as the dollar weakened from the stronger pulse of global growth, US inflation expectations would rebound, allowing for a steeper path for Fed rate hikes.
Unfortunately, such a scenario doesn’t appear likely over a 6 to 9 month horizon.