A weak dollar was the 'secret sauce' for calming markets, now is causing problems

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The falling U.S. dollar was the secret sauce that restored calm to global markets this spring. Along with rising commodity prices, the turn in the greenback helped take some of the pressure off emerging-markets governments while reassuring investors in developed markets that deflation and recession were not around the corner after all.

Welcome though it appears to have been, a weaker dollar was not what most investors were expecting at the start of 2016. The majority had expected to see the dollar go higher on the back of rising U.S. interest rates and further moves to loosen monetary policy in the euro zone and Japan before stabilizing for the balance of the year.

Instead, the dollar fell by more than 6 percent on a trade-weighted basis between the middle of January and the end of April. It has since regained some of that ground. But a crucial question for all investors looking to the second half of 2016 is whether the start of 2016 was the beginning of the end for the strong dollar or just a temporary detour.

No one knows the answer to that question. We can make a good start, however, by asking why, exactly, the dollar has moved down, and what that tells us about the strength of the global recovery.

It would be good news for everyone if the dollar had lost ground because the rest of the world was getting stronger and more interesting to investors. Unfortunately, the evidence for this interpretation is mixed at best. Instead, the dollar seems to have weakened largely because of changing expectations around U.S. interest rates.

If that is correct, then markets could have a bumpy second half of the year as the Fed gets back on track in raising interest rates and investors wonder whether the other benign forces supporting asset prices in the first half are also about to unwind.

It is true that many countries outperformed the U.S. in growth terms earlier this year — notably the euro zone and Japan, both of which saw their national output rise at an annualized rate of close to 2 percent, higher than expected. But the larger growth surprise, relative to expectations at the start of the year, was in the U.S., and it was not a happy one. Annualized growth of U.S. gross domestic product was only 0.8 percent in the first quarter, even after upward revisions.

Those GDP numbers were not yet available early in the year, when the dollar was falling. What we saw at that time
was a rush for safe havens, like the Swiss franc, in response to jitters about a global recession, which would often translate into a weaker dollar. When the market fears receded, we did not see any equivalent recovery in the greenback, though we did see commodity prices stage a tremendous turnaround.

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At the end of May, the price of Brent crude was about 70 percent higher than its low point in mid-January, and the Bloomberg world commodity index was up by nearly 20 percent. It would therefore be reassuring to conclude that higher commodity prices spelled a stronger global economy and potentially waning demand for cheap money from the U.S.

Positive signs from China's economy and a more stable Chinese currency were certainly factors that pushed up commodity prices in the first part of the year — and, with that, many emerging-markets assets. Chinese policymakers are having more luck stabilizing the yuan, and capital outflows have slowed. Nonetheless, there is scant evidence of a fundamental turnaround in emerging-markets demand and corporate earnings.

In fact, like the big fall in prices we saw previously, the rise in commodities we have seen this year seems to have been driven not by booming demand but more by changing relative supply conditions.

That leaves us with a less encouraging explanation for the bulk of the weakness in the dollar: not greater activity abroad but signs of even prolonged inactivity by the Fed.

Both the Bank of Japan and the European Central Bank have loosened monetary policy further since the start of the year, but neither move was exactly a surprise. The significant change, relative to expectations, was in the U.S.

At the start of 2016, U.S. central bank policymakers were forecasting as many as four rate increases in the course of the year, whereas market participants were pricing in about two. The market jitters led the Fed to take yet another dovish turn, though. Market forecasts for rate rises were pushed into the autumn, and chair Janet Yellen has signaled in various speeches and testimonies that she still thought the world is a dangerous place.

The Fed's stance explains why fixed-income markets had such a strong start to the year, even as many equity markets in developed and emerging economies alike regained some lost ground. Yet there was also a lurking worry that what the Fed had given, it could taketh away — particularly when the Fed was facing not just strong employment demand at home but flat productivity and rising inflation.

That productivity slump is taking its toll on corporate profits. It is also putting upward pressure on core inflation, which is now rising at an annual rate of 2.6 percent, compared with an average of 1.8 percent in 2014 and 2015.

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What is causing this productivity slump and how long it will last are questions that policymakers and economists will continue to debate. But faced with this combination of data, the Fed has to take seriously the idea that the U.S. economy's sustainable long-term growth rate is now quite a lot lower than in the past — even if labor force participation continues to make up some of the ground lost since the late-2000s financial crisis.

The weaker dollar and higher cost of energy also stand to push up headline U.S. inflation quite sharply in the months to come. It all points in the direction of gradually tighter U.S. monetary policy, with perhaps two rate increases in the second half of 2016.

Rising inflation, in the U.S. and globally, and a less supine Fed will make the backdrop for emerging markets more challenging — and will make it harder for central banks to cut interest rates in countries such as Mexico, India and South Africa to boost their slowing economies. It also poses a distinct possibility that the dollar will go straight back up again.

We have already seen the seeds of such a turnaround in May, when senior Fed policymakers sent signals that a summer rate increase was still a distinct possibility. The MSCI emerging-markets index fell by nearly 5 percent in May, whereas the trade-weighted dollar index rebounded 3 percent. There have also been some warning signs in China, where officials are suggesting that they will not be as aggressive in propping up demand through infrastructure spending as they were in the years after the financial crisis, and the effects of monetary stimulus earlier in the year appear to be wearing off.

Against this mixed backdrop, many investors are now feeling extremely cautious, though the mood is calmer than at the start of 2016. According to the May 19 survey of market sentiment by the American Association of Individual Investors , slightly more than 19 percent of U.S. investors currently describe themselves as "bullish."

Historically, a low figure like that has been something of a buy signal for contrarian investors. On the 26 previous occasions when sentiment has been this bearish, the U.S. equity market has rallied by more than 10 percent in the following six months. When so many fundamental questions about the breadth and strength of the global recovery have not yet been resolved, it's no surprise to see investors hesitate to pile into global risk assets.

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