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Dollar Doldrums Mean Easier Money

19 Jul 2017 4:34 am

By Ben Eisen

A deep decline in the U.S. dollar this year is easing the flow of money through the financial system, potentially queuing up a face-off between investors who are betting on loose financial conditions and Federal Reserve officials who want them tighter.

The Goldman Sachs Financial Conditions Index, a widely-watched gauge, was at its lowest since late 2014 this week. The lower the index, the looser the flow of money, based on factors like bond yields and the value of the dollar against its peers.

Much of that is the result of a falling greenback. The WSJ Dollar Index, a measure of the U.S. currency against 16 others, is down 6.5% since the end of last year. The index was down another 0.6% Tuesday morning at its lowest level since October, before the presidential election spurred a big surge in the dollar.

Investors had bet on a stronger dollar in the immediate aftermath of the election, reasoning that faster economic growth and higher inflation under the Trump administration would lead the Fed to lift rates faster. That's reversed in recent months as economies around the world have proven surprisingly strong relative to the U.S. The dollar continued its decline Tuesday after Republican Senators withdrew a controversial health-care bill.

The lower trade-weighted dollar has been the most important factor loosening financial conditions over the past week, according to Goldman Sachs. (Rising equity prices and a falling 10-year Treasury yield have also been important contributors).

Financial conditions are loosening in part because investors are starting to question whether the Fed can lift rates as fast as it hopes, with Mr. Trump's policy agenda in Washington stalled and inflation dropping below the central bank's 2% target. In the fed funds futures market on Tuesday morning, traders saw just a 48% chance of at least one more rate increase this year, according to CME Group. That's down from about 60% at the end of March.

Typically Fed rate increases tighten financial conditions, restricting credit to keep the economy from overheating. And indeed that did happen after the Fed's first rate increase in 2015. But financial conditions are now looser than before the central bank started its tightening cycle, an environment that can encourage leverage in the financial system. Fed officials are taking note.

"The general rise in valuation pressures may be partly explained by a generally brighter economic outlook, but there are signs that risk appetite increased as well," said Fed Vice Chairman Vice Chairman Stanley Fischer in prepared remarks late last month. He added: "The evidently high risk appetite has not lead to increased leverage across the financial system, but close monitoring is warranted."

Loose financial conditions don't appear to be an imminent concern. But the more financial conditions loosen in the face of a Fed tightening cycle, the more the Fed's view is likely to be at odds with investors.

(END) Dow Jones Newswires

July 19, 2017 00:34 ET (04:34 GMT)

Copyright (c) 2017 Dow Jones & Company, Inc.
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