It's A Currency War... The Fed Fears Deflation

by: Edward Hoofnagle, CFA

Fed is worried about the world damaging our fragile economy, but refers only to crude high-level international metrics.

Most participants feel we're at full employment, but afraid of ongoing deflationary push.

Several notes that central bank options are limited to absorb future shocks.

I am always amazed at how quickly a text-based algorithm can count specific words in a document and extrapolate views. This was made blazingly clear by the market reaction to the minutes of the Federal Reserve meeting. Almost instantaneously, the markets start digesting and reacting to word counts. Then the speed-reading and writing pundits chime in, and headlines begin to waft on the wires - these also drive the market reaction.

Not me, it takes me a good 4 or 5 hours to read the minutes. I spend time re-reading, highlighting and comparing notes across the minutes. Then it takes a few hours to write down the key points and guess at how it will affect my investments.


Some interesting notes. The Fed has become the world's money market desk, and was judiciously discussing whether to offer term Repos over the quarter-end. After some deliberation, they opted NOT to cross the quarter, relying solely on the Overnight Repos - this was probably one of the factors that wreaked havoc on short term rates during March 30 - April 1.

The Fed has many indicators for domestic activity, and they use these metrics to comment precisely on various aspects of the domestic economy. In contrast, when they wring their hands about international developments, the Fed seems to be regurgitating headlines. For example:

Domestic (Precise measures):

  • Nonfarm payrolls increased
  • Unemployment declined
  • Share of workers employed part time declined
  • Rates of private sector job openings, hires and quits rose
  • 4 week moving average of claims for unemployment declined
  • Labor compensation increased
  • Average hourly earnings increased

International (High-level measures)

  • Foreign real GDP growth slowed
  • Canadian activity restrained
  • Japanese economy contracted
  • Economic growth in the euro area, UK and Brasil
  • Economic growth in emerging Asian economies
  • Softening of growth in China
  • Inflation in advanced foreign economies
  • Inflation in China
  • Inflation in South America
  • Actions by BOJ and ECB

Hmm…seem strange doesn't it? The Fed digs deeply into the US economy, discussing very granular and specific elements of the economic puzzle, but when discussing international events, it seems disjointed and high-level. And that wouldn't be so bad, except their entire premise for not raising rates is BASED on the international worries!

Reading between the lines, the Fed seems to be desperately fighting the USD advance over the past 12 months , highlighting repeatedly that the strong USD and weak oil is causing deflation, while worrying that further rate advances will only exacerbate the dollar increase and its deflationary push.

The currency war is dead! Long live the currency war!

The Staff Review and Outlook

Here is where the career economists get to list all their favorite metrics in support of their view on the economy:

Current Situation


Financial markets turbulent (global worries, US worries)

GDP will increase more slowly than prior

Domestic conditions eased in Feb (stock prices rose, volatility fell, credit spreads narrowed)

Inflation growth estimate (long term) was lowered

Dollar depreciated

Risks to GDP forecast on downside

Long term sovereign bond yields declined

Neither monetary nor fiscal policy is well-positioned to absorb future shocks.

5 and 10 year US yields fell then increased

Risks to unemployment forecast skewed to upside

Inflation compensation x<5 increased, consistent with oil; long-term was unchanged

Risk to inflation forecast on downside, especially if USD appreciates again

Financing conditions accommodative, but credit quality deteriorated

Downgrades outpaced upgrades

Commercial real estate financing tightened

Participants View

This is where all the big wigs get to comment.

  • Confidence in labor market is strong
  • Fear that increased consumer spending will be offset by weak exports
  • Investment seemed sluggish
  • Underlying global factors are not fully resolved, pose ongoing downside risk
  • Motor vehicle sales and consumer confidence seem high
  • Fundamentals for housing are strong
  • Capital spending was soft
  • Outlook for growth abroad has dimmed, which could strengthen dollar
  • Some debate about whether US was at full employment
  • Foreign growth slowing, will reduce exports
  • Persistence of deflationary pressures
  • Longer term inflation expectations may be slipping lower
  • Financial market turbulence provided a reminder that the ability of central banks to offset the effects of adverse economic shocks might be limited. (this one was my favorite)


The world is dangerous and scary, and we're afraid the markets will tank and that the dollar will spike upwards if we act. And even though we have reached record levels of employment, we still can't shake the deflationary spiral because that pesky oil price keeps falling, so we're screwed. And we fear if we raise rates, it will cause declines in the stock market which will spook the consumer, resulting in a recession for which we are unable to provide significant traditional monetary support because we've sat on our hands for the last 6 years.

So, do nothing! We're in a currency war, after all, and if we pull the trigger to raise rates, we're going to get squashed! Plus, if we do nothing, we can force other central banks to try to find ways to act. Let's see what Draghi and Kuroda-san have to say.

Of course, we can't say that, so let's just say:

"…they saw global economic and financial developments as continuing to pose risks"

Investment Implications

We're not out of the woods yet. Make sure your risk is aligned to your ability to weather volatility.

Go easy on SPY, hedge it out, maybe even a small short position.

Cash and Short term fixed income only, stay away from junk

Gold GLD is hard to call, the deflation scare and rate increases are the flies in the ointment. Have some in the portfolio, but don't go crazy.

This is not the time for leverage, keep some powder, and keep an eye on indicators like JNK, and VXX. If JNK falls below 33, we're back to fear mode in the fixed income markets. And if VXX spikes above 22, we're back into the topsy turvy.

Disclosure: I am/we are long US AND INTERNATIONAL EQUITIES. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am also short certain stocks. This article is not intended to be investment or trading advice, the intention is to illustrate the link between economic analysis and financial markets for educational and discussion purposes. Investors should do their own research and/or use an investment professional.