Be Prepared for a Cheaper US Dollar
When will the strong US dollar weaken? Ultimately, the answer is whenever the US Treasury wants.
When the US Treasury is not overly concerned with the US dollar, market forces can prevail to raise or lower the exchange rate compared with euros, Swiss francs, yen or any other currency.
Sometimes, other central banks intervene to raise or lower their currencies relative to the greenback and the US does not seem to care.
China is notorious for this.
Japan and Switzerland are other practised currency manipulators.
The last fully coordinated currency market intervention was conducted by the G-7 in March 2011 at the time of the Fukushima, Japan earthquake and tsunami that caused the collapse of a nuclear power plant and, ultimately, a crash of the Tokyo stock exchange.
The Japanese economy was weakened by the natural disaster.
A weaker yen would have helped the economy with cheaper exports and more inflation.
But insurance companies had to sell US dollar-denominated assets and buy yen in order to pay yen-denominated claims for the disaster losses. The result was a stronger yen.
The G-7 intervention, organised by then French Finance Minister Christine Lagarde, successfully sold yen and bought euros, US dollars and sterling to weaken the yen despite insurance companies buying it.
Lagarde’s success in this intervention was instrumental in her elevation to head of the IMF shortly thereafter.
In short, except in extraordinary circumstances, the US Treasury does not directly intervene in currency markets to target US dollar exchange rates.
If such targeting is needed, the US Treasury will work with the Fed to raise interest rates or take a pause in rate hikes to affect the US dollar’s value.
High US dollar crimps US growth
All of this may be about to change.
Both President Trump and Treasury Secretary Mnuchin have publicly expressed dismay at the greenback’s persistent strength in the second half of 2018.
A strong US dollar has adverse effects relative to Trump’s economic plans.
It makes imports less expensive, which has a deflationary impact on the US domestic economy. This is at a time when both the Fed and the White House would like to see more inflation.
A strong dollar also hurts US exports from major companies such as Boeing and GE.
That hurts US competitiveness and US jobs.
Finally, a strong US dollar hurts corporate profits of US global companies because their overseas profits are translated back into fewer US dollars.
This is a headwind to US stock market performance.
The Fed is working against the Whitehouse
While the White House and Fed may be united in their desire to see a weaker US dollar and more inflation, the Fed is doing nothing to achieve that.
The Fed has been on a path of raising interest rates for almost three years, beginning with the ‘lift-off’ rate hike in December 2015.
Since October 2017, the Fed has also been tightening money supply by not reinvesting in US Treasury securities when existing securities in their portfolio mature.
This ‘quantitative tightening,’ or QT, is the opposite of quantitative easing, QE.
The combination of rate hikes and QT has caused a significant increase in US interest rates in all maturities and, in turn, a stronger US dollar as capital flows to the US in search of higher yields.
The result is a persistently strong US dollar.
This means that if the White House and US Treasury want a weaker US dollar, they may have to achieve it on their own with no help from the Fed.
The US Treasury is well-equipped to do this kind of intervention by using their Exchange Stabilisation Fund, or ESF.
The ESF was created under the Gold Reserve Act of 1934, which provided legal ratification for FDR’s confiscation of private gold from US citizens in 1933. FDR paid US$20.67 in paper money for the gold in 1933, knowing he intended to raise the price of gold.
His plan was to capture the ‘gold profits’ for the government instead of allowing citizens to realise the profits. Those profits were the original source of funding for the ESF.
Dipping into the money bucket
Importantly, the ESF exists completely outside of congressional control or oversight. It is tantamount to a US Treasury slush fund that the US Treasury can use as it sees fit to intervene in foreign exchange markets.
No legislation or congressional appropriation is required.
Former US Treasury Secretary Bob Rubin used the ESF to bail out Mexico in 1994 after Congress had refused to provide bailout money through other channels.
Today, the ESF has net assets of about US$40 billion.
The gross assets include about US$50 billion in SDRs, but the US Treasury can issue SDR certificates to the Fed in exchange for dollars if needed to conduct currency market operations.
The biggest offender in the currency wars today is China, which has devalued the yuan 10% in the past six months to offset the impact of higher tariffs imposed by Trump.
China’s cheap-yuan policy is undermining Trump’s trade war policies.
After biding their time, Trump and Mnuchin are ready to lower the boom on China with a cheap-dollar policy after the US midterm elections. Of course, China will not be alone in feeling the impact of the new, cheap dollar. Europe and the euro are also in the line of fire.
With this background in mind, what is the outlook for US dollar exchange rates?
The single most important factor in the analysis is that two currencies cannot devalue against each other at the same time.
It’s a mathematical impossibility. If one currency is going down against another, then the other must be going up. There’s no other way.
From January 2010 (when Obama launched the currency war) to August 2011 (when the US dollar hit an all-time low), the currency wars benefited the US at the expense of Europe, emerging markets and China.
This was considered necessary by the participants at the G-20 leaders’ summit in Pittsburgh in September 2009.
The US was and is the world’s largest economy. If the US could not escape the impact of the 2008 financial panic, no one else would, either.
In effect, the world would suffer stronger currencies while the US devalued to jump-start the global recovery.
After August 2011, the dollar was allowed to revalue upward while the rest of the world, especially Europe and China, was allowed to devalue so they could claim some benefit from a weaker currency.
This worked in the short-run, but the problem was that the US never returned to sustained growth at the prior trend of 3.25% growth per year.
Will it help Trump’s chances for 2020?
The US endured a long depression from 2007 until today, with annual growth of about 2.3%. Europe and China got a boost, but the US never pulled away from the pack.
Since then, it has been a matter of taking turns. The euro is allowed to depreciate to help growth and the banking system as the dollar gets stronger based on a slightly stronger US economy. But no major economy has solved the problem of achieving self-sustaining trend growth.
China has been free-riding the entire time.
There have been periods of a soft peg of the yuan to the dollar, but there are intermittent periods of a weaker yuan. China executed shock devaluations in August 2015 and December 2015.
Both times, US stocks fell 11% in a matter of weeks. China has just executed a 10% slow-motion devaluation over the past six months. US stocks have started to sink again.
Now Trump and Mnuchin are saying, ‘Enough!’ The Europeans will have to take their turn with a stronger currency and China will be penalised for their currency manipulation. A weaker US dollar is coming.
Whether this will be achieved with cooperation by the Fed or direct intervention by the US Treasury remains to be seen, but a weaker US dollar is the only way out of the US growth conundrum and debt debacle.
A weaker US dollar will give the US another growth spurt after the 2018 tax cuts to help propel Trump’s re-election prospects for 2020.
All the best,