The US dollar could still fall by around 0.50-0.75% if President Trump were to opt for Powell over Taylor as Fed Chair this week
We would view the widely speculated nomination of Jerome Powell as mildly negative for the US dollar as some of the ‘Taylor premium’ is priced out of US markets. Our estimates suggest we could see up to a 0.50-0.75% reversal in the DXY dollar index. The downside could be muted by the fact that a positive reassessment of US economic fundamentals – driven by both tax reform speculation and solid macro data – has contributed more to the US dollar’s rally over October. Plus, Taylor could still find himself on the FOMC within the vice-chair capacity.
What our economists describe as the continuity candidate, a Powell-led Fed is likely to stick to the script of a gradual policy normalisation. This policy stance also poses much less of a risk to potentially inflated stock markets, something which the President clearly uses as a gauge of his economic success.
We would view the nomination of Powell as mildly negative for the US dollar as some of the ‘Taylor premium’ is priced out of US markets. Our estimates suggest that we could see up to a 0.50-0.75% reversal in the DXY dollar index. Decomposing the dollar’s +2% rally over October into “real” and “monetary” shocks, we find that a significantly greater proportion of moves can be attributed to the real channel – that are factors causing a positive reassessment of US economic fundamentals.
While part of this real story is undoubtedly greater hype over US tax reforms, strictly speaking, it also incorporates the fact that US economic data has been fairly constructive in October – with our US Data Surprise Index having moved sharply higher on the month (see below).
The fallout in the US dollar might be muted for the added fact that Taylor could still find himself on the FOMC in some capacity, with the President still set to appoint three additional FOMC Governors, including a new Vice Chair to replace Stanley Fischer.
Yet, the bigger question we’re asking ourselves is whether Taylor as Chair or Vice Chair would actually be game-changing in the long-run? Assessing his recent rules-based academic literature, there are there areas where we note Taylor differs from the Fed's current ideology: (1) his estimate of what the real neutral interest rate (r*) is; (2) QE as central bank policy tool; and (3) the role of the USD in the Fed policy reaction function:
Our variance decomposition of US financial markets is based on imposed restrictions on the relationship between US Treasury yields and a basket of risky US assets. A ‘real’ shock is one where US assets are positively correlated due to a reassessment of US fundamentals. A ‘monetary’ shock is one that has opposing effects on US yields and risky assets (Fed policy related). The decomposition allows us to describe daily changes in the DXY index.