Friday, June 24, 2016

The Fire Across the River Could Spread

     I'd like to offer a rebuttal to NDDs post about the potential impact of Brexit on the US.  To that end, consider these points from Fed President Lael Brainard:

The notable effects of recent crosscurrents from abroad should lay to rest any remaining lore that the United States is a closed economy. Financial linkages between the United States and foreign economies are immediate and extensive. Equity prices, long-term interest rates and risk spreads, and exchange rates show strong reactions to developments abroad, and, in recent months, foreign developments have at times been the dominant factor driving U.S. financial conditions. Weak foreign aggregate demand, as well as accompanying accommodative monetary policies in the euro area and Japan, and diverging expectations have been key among the factors causing a significant 10 percent appreciation of the dollar since last June. To the extent that exchange rate appreciation exerts a tightening force on financial conditions in the United States, it delays the return of U.S. interest rates to more normal levels

While trade is a smaller share of the U.S. economy than in many other economies, exchange rate changes of the magnitude seen recently can have large effects on aggregate demand.  We have already seen a large negative contribution of net exports to U.S. GDP growth in the past two quarters. In addition, because some models estimate that exchange rates’ effect on net exports can last up to three years, it is possible that the drag from net exports will persist for some time.

Downgrades to foreign growth affect the U.S. outlook through several channels. First, weak growth abroad reduces demand for U.S. exports. Second, the expected divergence in U.S. growth increases demand for U.S. assets, putting upward pressure on the dollar, which, in turn, weighs on net exports. The estimated effect of dollar appreciation on net exports has been shown to be substantial and to persist for several years.  Weak demand weighs on global commodity prices, which, together with the effects on the dollar, restrains U.S. inflation. Finally, the anticipation of weaker global growth can make market participants more attuned to downside risks, which can reduce  prices for risky assets, both abroad and in the United States--as we saw in late August--with attendant effects on consumption and investment

Over the past year, a feedback loop has transmitted market expectations of policy divergence between the United States and our major trade partners into financial tightening in the U.S. through exchange rate and financial market channels. Thus, even as liftoff is coming into clearer view ahead, by some estimates, the substantial financial tightening that has already taken place has been comparable in its effect to the equivalent of a couple of rate increases.

     To Brainard's comments, here's a 5-year chart of the dollar:

While the overall value was moving lower, expect it to catch a strong bid thanks to the Brexit vote. 

     All of this is occurring when future US growth is slowing.  Consider this chart of the LEIs from Doug Short:

While the Atlanta Fed's GDP nowcast is predicting 2Q growth of 2.8%, the NY Fed's is lower at slightly over 2%.  And the long leading indicators are mixed: corporate profits are lower while building permits at moving sideways.  The only strong long leading indicators are M2 and Baa yields.

     I certainly hope that NDD is right about this.  But personally, I'm more concerned about the potential negative global feedback loops that exist.