Some Thoughts on Potential US FX Intervention

Press reports suggest an intense debate is raging within the Trump administration regarding a weak dollar policy. That it’s even being discussed marks a significant departure from previous administrations, where a strong dollar has typically been viewed as being in the best interests of the US.RECENT DEVELOPMENTS

Last Friday, White House advisor Kudlow ruled out any sort of currency intervention by the US. There is more to this story than meets the eye. While Kudlow made the statement during a live interview Friday, it appears that a serious debate is taking place between senior US officials about whether they should try to weaken the dollar and if so, the best method to do so. Direct FX intervention and jawboning were discussed and rejected. Kudlow apparently thought the matter was closed.

Apparently not, as President Trump further muddied the waters. He said late Friday afternoon that “I didn’t say I’m not going to do something” about the strong dollar, thereby contradicting Kudlow’s earlier statement. We’ve seen this sort of capricious policymaking before from this administration. While it’s clear that we cannot rule out FX intervention to weaken the dollar, we believe cooler heads will prevail and the US will limit its efforts to jawboning, which has limited impact.

Reports suggest Kudlow and Treasury Secretary Mnuchin have come out against a weak dollar policy. On the other side is trade advisor Navarro, who reportedly is advocating efforts to weaken the dollar by 10%. For now, Trump seems to be siding with the more orthodox Kudlow/Mnuchin camp.

If there were to be any FX intervention by the US, it would most likely be unilateral. There is simply no broad-based concern on the part of European or Japanese officials regarding a major “misalignment” of exchange rates. This is a very different environment than what was seen during the 1985 Plaza Accord (see A Brief History Lesson below).

Furthermore, it’s unlikely that unilateral FX intervention would have much lasting impact when interest rate differentials continue to favor the dollar. We remain dollar bulls and continue to believe that markets are overestimating the Fed’s capacity to ease after this week’s likely 25 bp cut. Elsewhere, the ECB and BOJ have signaled their intention to ease further this year. The BOE may be forced to cut rates in the event of a hard Brexit. The RBA and RBNZ have already started cutting rates, and the BOC will likely join them. Many in EM have already started cutting rates, with more expected to join in the coming months.

 

A BRIEF HISTORY LESSON

The so-called Plaza Accord of 1985 was a multilateral effort to drive down the value of the dollar. Many view it as the most important policy initiative in the FX markets since the end of Bretton Woods in 1973 brought floating exchange rates to the world. Due largely to the high interest rates under then-Fed Chair Paul Volcker (1979-1987), the dollar had gained nearly 45% (on a broad real trade-weighted basis) in the 1980-1985 period.

A prolonged period of tight monetary and loose fiscal policy drove up the value of the dollar. The strong dollar made imports cheap, leading to the growth of the so-called “twin deficits” in the budget and current account. Despite complaints from some trading partners, the US was not concerned yet with the strong dollar and so followed a policy of “benign neglect.” The US agreed to study potential FX intervention at the G7 Versailles summit of 1982, but nothing concrete emerged from the so-called Jurgensen Report.

Dollar appreciation continued, notably accelerating in the 1984-1985 period. At that juncture, it became widely recognized that the dollar’s appreciation could no longer be explained by the economic fundamentals. Interest rate differentials that favored the greenback peaked in June 1984, and so the continued appreciation of the dollar over the next year became viewed as being “misaligned.”

The seeds of the Plaza Accord were planted in January 1985. At the start of Ronald Reagan’s second term, Don Regan and James Baker switched jobs in the cabinet, bringing a different perspective at Treasury. Incoming Treasury Secretary Baker (formerly Chief of Staff) signaled a less hands-off approach on the dollar, testifying at his confirmation hearing that the policy of “benign neglect” was “obviously something that should be looked at.”

It’s not widely known but some FX intervention was actually agreed upon at the January 1985 G5 summit. The US followed up with some limited FX intervention, but Germany in particularly sold dollars very aggressively in February and March 1985. It’s worth noting that the dollar peaked during that period.

It’s clear then that the shift in FX policy had already begun before the Plaza Accord was finalized. G7 Finance Ministers and central bankers met September 22, 1985 at the Plaza Hotel in New York City. After that meeting, it was formally stated that “some further orderly appreciation of the non-dollar currencies is desirable” and that policymakers “stand ready to cooperate more closely to encourage this when to do so would be helpful.” The dollar went on to lose about 22% over the next two years.

The Plaza Accord worked so well that policymakers eventually agreed on the so-called Louvre Accord. At the February 1987 Paris meeting of G7 Finance Ministers and central bankers, it was agreed that the value of the dollar was now “consistent with economic fundamentals.” Officials also announced that they would only intervene when required to ensure stability in the FX market. Yet the dollar’s slide continued after the Louvre Accord.

 

ECONOMIC OUTLOOK

Despite President Trump’s vocal concerns about the strong dollar, we do not think it has had a noticeable impact on US growth. The labor market remains strong, which in turn is very supportive for consumption. The preliminary Q2 GDP report put US growth at 2.1% SAAR. While down from 3.1% SAAR in Q1, the economy is still growing above trend (~2%). The NY Fed’s Nowcast model currently has Q3 growth at 2.2% SAAR. The IMF just upgraded its forecast for US growth this year from 2.3% to 2.6%.

Many (including us) continue to question the need for a Fed rate cut. Yet Powell has painted the Fed into a corner and a cut this week seems as close as one can get to a done deal. It’s the back-month expectations that need to be adjusted, as the implied yield on the January 2020 Fed Funds futures contract of 1.73% still suggests two more cuts are expected after this week. When the US rates markets finally adjust to the reality of a robust US economy, the dollar is likely to take another leg higher.

 

INVESTMENT OUTLOOK

Unilateral FX intervention rarely has any lasting impact on exchange rates. Think of the countless times the Bank of Japan has intervened to try and weaken the yen. One notable exception is the coordinated G7 FX intervention to reverse yen gains after the 2011 earthquake in Japan. USD/JPY moved from a low near 76.25 in March 2011 up to around 85.50 in April 2011. Even then, yen strength resumed, and USD/JPY hit a low near 75.35 in October 2011 before reversing higher.

When (if?) market expectations readjust for a less dovish Fed, it should be dollar-positive and bond-negative. Indeed, we retain our bullish dollar call for H2 2019, but we expect to be tested many times on our conviction until the current recession fears fade away. The equity implications of a less dovish Fed are not as clear-cut. The liquidity story would turn more negative, but the US economic outlook would turn more positive. Net net, we suspect US equities would continue to move higher.

Of course, these broad macro investment calls are all predicated on a continued economic expansion in the US. If the economy slows or goes into recession, then the Fed will have no choice but to cut rates more aggressively then we are anticipating. If so, this would be a game-changer for the dollar. Why? Because the policy mix would change from the current dollar-supportive one (tight monetary and loose fiscal policy) to one that is dollar-negative (loose monetary policy and tight fiscal policy).

Lastly, pursuing a weak dollar policy would be a very dangerous strategy for the administration. US debt issuance is set to explode further after Congressional passage of the 2-year spending plan. No foreign investor will feel confident buying US Treasuries if their expected returns are likely to be eaten up by a depreciating dollar. Recent UST auctions have seen low bid-to-cover ratios. While some of this may have been due to the then-looming (and now solved) debt ceiling issue, the trend bears watching in the coming weeks.

Bottom line: Even if the US were to adopt a weak dollar policy, we think the fundamentals still support a stronger dollar. Unilateral US actions may temporarily weaken the dollar, but our more constructive view of the US economy keeps us in the dollar bull camp.