In May the US commerce department requested powers to impose tariffs on nations with undervalued currencies. Hot on its heels, the Treasury published its FX manipulation report, expanding the criteria for defining currency manipulation.
It’s no secret that the Trump administration prefers a weaker USD. And I believe these actions are part of a broader move to reverse the United States’ traditional ‘strong dollar policy’…
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In May the US commerce department requested powers to impose tariffs on nations with undervalued currencies. Hot on its heels, the Treasury published its FX manipulation report, expanding the criteria for defining currency manipulation.
It’s no secret that the Trump administration prefers a weaker USD. And I believe these actions are part of a broader move to reverse the United States’ traditional ‘strong dollar policy’.
When the US first committed to the ‘strong dollar policy’ under Clinton in 1995, the dollar halted its decade long slump and rose 30% in the next seven years (chart 1). It was a critical turning point for FX and a massive investment opportunity.
But before we make predictions from this one data point, there are two things to consider:
1. There were special factors in 1995.
The dollar didn’t strengthen just because Robert Rubin, the US treasury secretary at the time, said it should. Later Treasury secretaries who made similar pronouncements failed to secure the same effect.
This was down to the context. In particular, three conditions made the ‘strong dollar policy’ a critical turning point
- Previous administrations, from Reagan to early Clinton, had persistently pushed Germany and Japan to strengthen their currencies. Rubin’s strong dollar policy was meant to convey that the US would no longer seek a currency solution to trade imbalances. This was a meaningful change in policy and, importantly, it was a green light for others to devalue.
- The dollar had become extremely undervalued at the time. The Japanese economy had collapsed, partly due to calamitous yen-strength (USDJPY @80), and the Deutsche Mark was at EURUSD equivalent of 1.38 at the time.
- The US economy was in the initial stages of outperformance vs. the rest of the world – the tech boom of the Clinton era was just getting started.
2. The Triffin dilemma.
Don’t stop reading! This is really important!
The US dollar could never have become an international currency unless the US had implicitly agreed to supply it to the rest of the world.
That may sound obvious, but it makes sense when thought about in the following terms.
Let’s say the only international currency in the world is gold and only one country holds all the gold mines – let’s call that country ‘Gold Country’. Everyone else needs gold to serve as a currency with which to trade. If Gold Country stops supplying gold to the rest of the world, international trade collapses. How does the world acquire gold from Gold Country? There are two avenues. First, Gold Country runs a trade deficit in goods with RoW and so pays out gold as payment. Second, Gold Country’s central bank deliberately expands the supply of monetary gold beyond what is appropriate for Gold Country’s economy, prompting people to carry that extra gold out of national borders for higher returns. In other words, either the Gold Country runs trade deficits with the rest of the world, or it runs an easier monetary policy than everyone else.
Now translate this scenario onto the dollar today. The Trump administration wants to reduce US trade deficits through policy. This chokes off the supply of US dollars to the rest of the world, making dollars scarcer and thus more valuable (stronger). The policy to run smaller deficits is therefore not consistent with a desire to weaken the dollar. You can’t have your cake and eat it! It is no accident that the value of the dollar and the growth of international trade are inversely related (chart 2).
Two Ways to Devalue the Dollar: Amateur vs. Pro
As argued above, I believe an attempt to narrow US external deficits and weaken the USD will fail.
If the US intervenes in trade to narrow its deficit, the counterpart’s currency will fall due to market forces (thereby strengthening the USD). If the US wants to weaken the USD, it will have to agree to increase the supply of its currency either by tolerating wider deficits or pursuing higher inflation at home (as explained above).
An amateurish attempt to devalue the dollar would involve jawboning or bully-pulpit actions (tweets, tariffs, and threats). This will cause market volatility through knee-jerk reactions and probably result in a stronger rather than weaker dollar. Eventually, when the ensuing chaos disrupts the real economy, the Fed would have to intervene and ease monetary policy. So yes, the dollar comes down, but at the end of a deep, dark tunnel.
A smarter way to weaken the dollar would be to stop targeting the trade deficit (make that damn trade deal!) or commit the Fed to a higher inflation target. I believe the Trump administration gets this now. The path may not be straight, but I believe this is where we are headed over the summer.
Entering Asia into the Equation
China is at the epicentre. There is a long term and a short term perspective here.
In the long term, China wants to replicate the US path to currency internationalisation. In order to achieve this, it must rely on a consumer-driven economy and run current account deficits.
But in the short term, China is stuck. On the one hand, it’s on the wrong side of Trump’s trade war, but on the other hand, it faces a crisis of confidence if it devalues its currency. Under pressure, it has resorted to increasing short term external borrowing to stabilize its FX reserves (chart 3) – a terrible, terrible idea.
I am certain there will be plenty of drama around US-China trade talks at (and beyond) the G20 summit on 28 June. Both sides are playing a game of chicken, and neither is willing to back down.
My advice: ignore the drama, read the playbook. The Trump administration will get the Fed to cut and then make some sort of a deal with China. The end result – a much weaker dollar.
Chart 1: Rubin’s “Strong dollar policy” marked a crucial turning point
Source: Morgan Stanley Macro Trading
Chart 2: International trade growth and US dollar value are inversely related
Source: Morgan Stanley Macro Trading
Mirza is a macro strategist, specialising in Asian FX and fixed income markets. Mirza is currently working as a desk analyst at Morgan Stanley, prior to which he worked in macro strategy roles at BNP Paribas and Deutsche Bank
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)