Dollar completes growth phase

Fed Chairman Powell said last week that the Fed rate is now at levels just below neutral. This message is markedly different from the position of the Fed a couple of months ago in the direction of easing and actually indicates the end of the dollar growth cycle.

There are no other mechanisms capable of supporting the trend towards the strengthening of the dollar. Trump's tax reform did not produce the expected effect, economic growth is slowing down, the trade balance is still updating lows, and even the announcement of agreements reached at the G20 summit with China will have a very short-term effect.

The only mechanism that is now seriously considered as a bullish factor for the dollar is a reduction in the Fed's balance sheet. It is believed that further reductions will lead to a liquidity deficit, but this conclusion contains serious flaws.

Consideration of the mechanism for reducing the Fed's balance sheet leads to the opposite conclusion, reducing the balance and monetary base does not lead to a liquidity deficit, and therefore is not a factor that objectively contributes to the strengthening of the dollar.

The Fed during the QE paid commercial banks a percentage of excess reserves. It was a special mechanism introduced in October 2008 as part of the fight against the financial crisis. Commercial banks do not keep their reserves in the overnight market, that is, reducing the practice of lending their excess reserves to each other, but keep them in special accounts of the Fed, because they can get a stable and guaranteed income for reserves.

And all because the Fed began to pay the balance more than the overnight rate. Due to this mechanism, the Fed attracted to the accounts of 2.8 trillion dollars of excess funds of commercial banks, much of which was used in conducting quantitative easing operations.

Since the beginning of the rate growth cycle in December 2015, the rate on excess reserves also synchronously rose, but by a smaller amount, and at the moment both rates became equal at the level of 2.20%.

The Fed's actions have expectedly led to the fact that it has become less and less profitable for commercial banks to keep excess reserves in the Fed's accounts.

Thus, the policy of reducing the balance of the Fed is reduced to several complementary operations. The Fed reduces its balance sheet without refinancing the income from redeeming government bonds but returns the money to the banks. Commercial banks, in turn, take the surplus from the Fed, as it is less profitable to keep them there and maintain high demand in the debt market since bond yields are growing faster.

These actions lead to a reduction in the Fed's monetary base, which, under other conditions, should have increased the demand for the dollar and, accordingly, its value. But, as can be seen from the graph below, the reduction of the monetary base is slower than the redundant reserves are reduced, that is, there is actually no less money in circulation, but even more, because the growth rate of the US public debt is growing at a faster rate, and financing the budget deficit returns all the proceeds back into circulation.

We summarize. Reducing the balance of the Fed does not lead to a liquidity deficit, and therefore is not a driver for the strengthening of the dollar. Consequently, the only really valid driver is the continuation of the cycle on the Fed interest rate growth.

In this regard, it is necessary to proceed from the fact that the insider about the likely shift in the range of neutral rates, which the Minister of Finance Mnuchin defends in negotiations with the Fed, will simultaneously mean the termination of the growth of the dollar due to the lack of growth factors.

Finally, the market will draw conclusions about the trend reversal after the publication of the employment report on Friday. Only a very good report exceeding market expectations in key positions will provide an opportunity to hope that the Fed will not rush to announce the end of the rate increase cycle. Any other result, especially negative in terms of wage growth rates, will be able to lead to a dollar reversal and the formation of a long-term basis.