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The Fed and the Dollar / Inflation Conundrum

February 1, 2021 | Commentary

  • Popular market commentary has recently been focused on the declining dollar and the potential for accelerating inflation.  There are compelling arguments behind these perspectives, but the forces at work today have not produced firm linkages in earlier years, so there is room for alternative outcomes.
  • Real interest rates, which adjust market rates for the impact of inflation, have declined in the United States as the Federal Reserve stays committed to a zero nominal Fed Funds rate policy and inflation has begun to inch up.  CPI inflation over the next several months is likely to show elevated readings as the economy recovers from the highly depressed levels of Q1-2020.  This should continue to press real interest rates lower.
  • The dollar has fallen around 12% from its peak in March, raising concerns about secular weakness. Rarely mentioned is the fact that the March top occurred in reaction to COVID-19 concerns and a flight from risk assets.  Over the entire past year, the dollar decline is closer to 3%, and it remains well within the range of the last five years.
  • Investors cannot ignore the potential risks from large deficits, potential inflation, and shifting currencies, but the right approach is a careful asset allocation that incorporates those risks, and not short-term macro themed trades trying to guess turning points and trends.
  • The Federal Reserve can persist in their zero-interest rate policy and aggressive quantitative easing if inflation stays in a low range.  However, if growth and inflation move up real interest rates will ratchet further into negative territory, encouraging more borrowing.  There may be a tipping point where the demand for high quality debt is insufficient to cover the growing public and private supply.  If the yield curve steepens meaningfully the Fed may find itself no longer shaping the fixed income market but trying to catch up to it. 

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