Back in the day, macroeconomists used one of two models to think about how central banks steer economies. For a big economy, with modest international trade and capital flows, the model ignored the rest of the world. The central bank, by changing liquidity conditions, raised and lowered interest rates. Changing interest rate levels drove interest sensitive sectors up and down, thereby tightening or loosening slack in the economy. Inflation rose or fell, depending upon the tightness or slack in domestic markets. For a small economy, with large international trade and capital flows, the model highlighted rest of the world dynamics. In this model, global capital markets set the interest rate. The central bank, by changing liquidity conditions, raised or lowered the value of the currency. A rising currency would restrain growth and weigh on inflation. A currency in retreat would do the opposite. The U.S. was the poster child for the large closed economy. Canada was the prototypical small open economy.

Quite strikingly, over the last two decades, U.S. monetary policy seems to be operating via the currency, not via interest rates. One can argue that enormous global capital flows now dominate the U.S. interest rate picture. Changing monetary policy conditions are therefore reflected in the movements of the dollar. Consider the table below:

	June 2014	Early March 2015	Early April 2015
Six-month non-farm payroll avg.	209	281	126
$/Euro	135	105	110
Fed funds implied forward rate	2.00%	1.40%	1.00%
U.S. 2-Year Note	0.48%	0.73%	0.49%
German 2-Year Note	0.05%	-0.20%	-0.25%
Spread	0.43%	0.93%	0.74%
U.S. 10-Year Note	2.60%	2.24%	1.85%
German 10-Year Note	1.40%	0.40%	0.19%
Spread	1.20%	1.84%	1.66%
WTI, $/bbl	105	50	50
Brent, €/bbl	82	55	51

Over the second half of 2014, into early 2015, U.S. economic activity accelerated materially. Reflecting this strong data, FOMC officials reaffirmed their intentions to raise overnight interest rates, starting in the second half of 2015. According to the model forecast from FOMC members, 12/31/2016 now stands at 1.85%. In stark contrast, European stagnation and falling prices in 2014 elicited a new pledge to deliver aggressive QE. This sparked a wild decline for continental sovereign yields.

Commitment by the U.S. to tighten, laid alongside newfound guarantees of aggressive European QE, catalyzed a wild rise for the dollar versus the euro—the climb touched nearly 25% from mid-2014 through early March of this year. This fantastic rise, in combination with the plunge for the yield levels of most developed world sovereign debt, created large demand for relatively high yielding dollar denominated debt. As a consequence, we witnessed the seemingly perverse spectacle of falling U.S. interest rates, amid data that strongly supported the notion of a rising fed funds rate. Even instruments directly tied to fed policy acted perversely. December 2016 fed funds contracts were priced for a 2% fed funds rate in June of 2014. On the day the jobs data printed a blistering February report, the contract closed at a price that implied a 1.4% fed funds rate for close of business 2016.

Over the last month dynamics were much more traditional. The economic news in the U.S. was overwhelmingly disappointing. Both the U.S. dollar and U.S. interest rates fell. We suspect that set of linkages will prove transitory. If the March weakness was largely weather, spring will reverse the news in the months ahead.

In which case, we suspect that the U.S. interest rate/currency interplay will resume. Rebounding confidence in a relatively strong U.S. economy will initially push U.S. interest rates back up. Once the rise is sufficient to rekindle belief in a one-way dollar bet the rise for U.S. interest rates will likely peter out. And it likely will end well before it validates the assertions of the FOMC about their current plans for the U.S. overnight rate. Finance Professors spent many decades reminding people that forward rates overstate expected future rates, a consequence of a persistent term premium. With short rates negative in half a dozen European nations, it looks increasingly like the term premium right now is sharply negative.

What might change all of this? Look to the bund. If economic circumstances pan-Europe took a sharp leap up, then we would see a radical re-pricing of European sovereign debt. In such circumstances U.S. interest rates would likely jump as the term premium changed sign. Note however, that this still amounts to the U.S. operating in the small open economy model. Interest rates will be rising. But they will have been set by global capital markets, not the U.S. central bank.