FX Update: Jackson Hole scenarios

Jackson Hole: a pivotal signal from the Fed dead ahead?

It’s been years since the annual Jackson Hole symposium hosted by the Kansas City Fed has generated as much attention as this year's powwow. The theme this year is “Structural shifts in the global economy”. Not particularly specific, but some possible big hints, given the massiveness of the topic. Is the title meant to suggest an update of the remarkable ECB President Lagarde speech back in April titled “Central banks in a fragmenting world.”? That speech got far less attention than it deserved.  In it, Lagarde outlined a number of geopolitical developments that required the central bank’s attention, most importantly the need for the central bank to support investment that lowers the risk of supply shocks stemming from an increasingly fragmenting world (Covid having laid bare the excess reliance on China for supply chains and the Russian invasion of Ukraine making Europe’s energy supply chains suddenly so fragile and more expensive). The paragraph below is perhaps the most crucial one in that speech:

"For example, if fiscal and structural policies focus on removing supply constraints created by the new geopolitics – such as securing resilient supply chains or diversifying energy production – we could then see a virtuous circle of lower volatility, lower inflation, higher investment, and higher growth. But if fiscal policy instead focuses mainly on supporting incomes to offset cost pressures (in excess of temporary and targeted responses to sudden large shocks), that will tend to raise inflation, increase borrowing costs and lower investment in new supply."

What would a Fed Chair Powell speech equivalent of this speech be this Friday (1405 GMT)? Something along the lines of the same: supporting US fiscal objectives which are largely intended to avoid excessive reliance on China/Taiwan for strategically important goods, most notably semiconductors. Those are the Biden administration’s Inflation Reduction Act and CHIPS and Science Act, which are remarkable in helping to drive expanding deficits at a time of virtual full employment. At the same time, the Fed has to at least hint that it is considering the elephant that everyone knows is in the room: unsustainable debt dynamics that will quickly worsen with these high deficits (which will only worsen further  in a recession) and as new treasury issuance rolls into higher yield territory.

What to do then? The old answer would have been to stop quantitative tightening and restart QE. But this is not yet acceptable when the inflation dragon has yet to be slain and labor markets are so tight. Rather, there is wide-ranging speculation that the Fed could be preparing the market for policy shifts that improve the demand dynamics for US treasuries in order to at least delay the spiraling risk of higher long rates due to “fiscal dominance”. This paper has gotten considerable attention on that front and suggests that lower interest on bank reserves to zero would help stave off a rising rate spiral by forcing banks to pay less on deposits, thus both lowering bank earnings and effectively taxing depositors with “real losses” via an inflation tax as banks can’t offer attractive yields on deposits. This would also encourage depositors to buy treasuries directly themselves. Market outcomes: hard to discern, if we get clear policy signals confirming the above, it is likely very bad for banks and possibly economic growth, but could also mean lower long yields – so most bullish for the yen?

Others see the Fed taking its longer run Fed policy rate projections higher (the projections published in the Fed’s quarterly “dot plot”). On that front, a Wall Street Journal op-ed from “Fed whisperer” Nick Timiraos put out over the weekend was titled “Why the Era of Historically Low Interest Rates Could Be Over” and argued that higher productivity and higher deficits are possibly set to reset the Fed’s attitude on the appropriate longer term policy rate. The hawkish surprise on this front would be language hinting that the September FOMC meeting will deliver a bump in the longer run rate projections, even if there is no pushback against the notion that is mostly priced that the Fed has reached its terminal policy rate for this cycle. Since 2019, the median longer term rate projection has been pinned at 2.5%. Market outcomes: A rise in the longer run rate projections would be the scenario most likely to deliver USD strength and risk-off.

The ”boring” scenario would be a discussion of the above without any solid takeaways or hints on either longer term implications or what the Fed is set to deliver at the September FOMC meeting. Market outcomes: the US dollar and other currencies will revert to their usual correlations with risk sentiment/China and yield direction.

Table: FX Board of G10 and CNH trend evolution and strength.

The USD and GBP strength (the latter on BoE leading the tables on further hike projections), while the smaller G10 currencies are still dragging on the weak risk sentiment up until yesterday’s and today’s huge surge. As noted above, the Jackson Hole conference has considerable potential to reset the narrative in the short term.

Table: FX Board Trend Scoreboard for individual pairs.

Sterling pairs look notably extended, with GBPUSD the only notable USD pair not firmly in USD rally territory (arguably together with USDCHF). The AUDNZD pair can’t make up its mind as it continues to triangulate.

Upcoming Economic Data Highlights (all times GMT)

• 1400 – US Richmond Fed Manufacturing Index
• 1830 – Chicago Fed’s Austan Goolsbee (voting member) speech
• 2000 – API's Weekly Crude and Fuel Stock Report
• 2300 – Flash Aug. Australia PMI’s
• 0030 – Flash Aug. Japan PMI’s