Trump’s Secret Currency War Weapon
When will the strong dollar weaken? Ultimately, the answer is whenever the president and Treasury secretary want.
When the Treasury is not overly concerned with the 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 dollar and the U.S. does not seem to care. China is notorious for this. Japan and Switzerland are other practiced currency manipulators.
Except in extraordinary circumstances, the U.S. Treasury does not directly intervene in currency markets to target U.S. dollar exchange rates. If such targeting is needed, the Treasury will work with the Fed to adjust interest rates to affect the dollar’s value.
All of this may be about to change.
China is the world’s biggest offender in the currency wars today. China devalued the yuan twice in 2015, crashing U.S. markets both times.
And Monday it devalued again. It was not a “maxi-devaluation” (5% or more in one day) but a “red line” devaluation because the exchange rate passed the psychologically important 7.00-to-1 ratio. The market panicked again.
The fact is, China’s cheap-yuan policy has undermined Trump’s trade war policies. And a strong dollar works against his economic plans. Both Trump and Treasury Secretary Mnuchin have publicly expressed dismay at the dollar’s persistent strength.
A strong dollar makes imports less expensive, which has a deflationary impact on the U.S. 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 U.S. exports from major companies such as Boeing and GE. That hurts U.S. competitiveness and U.S. jobs. Finally, a strong dollar hurts corporate profits of U.S. global companies because their overseas profits are translated back into fewer U.S. dollars. This is a head wind to U.S. stock market performance.
Now the Treasury Department has officially labelled China a currency manipulator, for the first time in 25 years. The move is largely symbolic, but it opens the door for additional sanctions.
While the White House, Treasury and Fed may be united in their desire to see a weaker dollar and more inflation, the Fed did nothing to achieve that until fairly recently. The Fed had been on a path of raising interest rates for three years, beginning with the “liftoff” rate hike in December 2015.
Only after last December’s stock market swoon did the Fed back off its interest rate hikes. And just last week it cut rates for the first time since 2008.
Since October 2017, the Fed was also tightening money supply through “quantitative tightening,” or QT, the opposite of quantitative easing.
The combination of rate hikes and QT caused a significant increase in U.S. interest rates in all maturities and, in turn, a stronger dollar as capital flowed to the U.S. in search of higher yields.
The result was a persistent strong dollar.
Now the Fed has discontinued QT two months ahead of schedule. So the Fed is no longer undermining its own desires for a weaker dollar. But the Fed cannot control the exchange rate with other currencies. It can influence them, but foreign central banks can counteract the Fed’s efforts by manipulating their own currencies.
But here’s where it gets interesting. If the White House and Treasury want a weaker dollar, they can achieve it on their own with no help from the Fed. The Treasury is well-equipped to do this kind of intervention by using their Exchange Stabilization 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 U.S. citizens in 1933. FDR paid $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 realize the profits. Those profits were the original source of funding for the ESF.
Importantly, the ESF exists completely outside of congressional control or oversight. It’s off-budget. It reports to nobody except the Treasury Secretary and U.S. President. It is tantamount to a Treasury slush fund that the Treasury can use as it sees fit to intervene in foreign exchange markets. No legislation or congressional appropriation is required.
For example, former 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 about $100 billion that it can use to manipulate currency markets.
Treasury Secretary Mnuchin reportedly opposes using the ESF to influence the dollar. So far he has persuaded President Trump to abstain from direct foreign exchange market interventions. But now that Treasury has labelled China a currency manipulator, maybe that will change.
After biding their time, Trump and Mnuchin are ready to lower the boom on China with a cheap-dollar policy. Of course, China will not be alone in feeling the impact of a new cheap dollar. Europe and the euro are also in the line of fire.
With this background in mind, what is the outlook for U.S. 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 dollar hit an all-time low), the currency wars benefited the U.S. 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 U.S. was and is the world’s largest economy. If the U.S. 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 U.S. 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 U.S. never returned to sustained growth at the prior trend of 3.25% growth per year.
The U.S. has endured a long depression from 2007 until today with annual growth of about 2.5%. Europe and China got a boost, but the U.S. never pulled away from the pack.
Since then, it has been a matter of taking turns. The euro has been allowed to depreciate to help growth and the banking system as the dollar has gotten stronger based on a marginally stronger U.S. economy. But no major economy has solved the problem of achieving self-sustaining trend growth.
China has been free-riding the entire time. Now Trump and Mnuchin are saying, “Enough!” They’re essentially saying the Europeans will have to take their turn with a stronger currency and China will be penalized for their currency manipulation. A weaker dollar is coming.
Whether this will be achieved with continued cooperation by the Fed or direct intervention by the Treasury remains to be seen, but a weaker dollar is the only way out of the U.S. growth conundrum and debt debacle.
Meanwhile, a weaker dollar will give the U.S. another growth spurt to help propel Trump’s reelection prospects for 2020.
The secret currency weapon is there. The question now is, will Trump use it?
for The Daily Reckoning