With the dollar continuing to outperform its peers and Trump’s protectionist policies well publicised, its hardly surprising that we’ve heard increased chatter about the prospect of US authorities intervening in the currency markets. Trump has been particularly vocal in recent months, expressing his concerns about the Fed’s stance on monetary policy and the fact that for a long time, the Fed were the only major central bank with a strong tightening bias, which in turn has fuelled demand for the dollar as investors search for yield. Meanwhile, he’s also accused both China and Europe (amongst others) of currency manipulation so it could well be a case of ‘if you can’t beat them, join them.’
Looking at the chart below, the dollar has been relatively stable over the past four years (on a trade weighted basis) certainly when compared to the extremes of the early 1980’s or the early 2000’s. However, for us in Europe, the strength of the dollar is arguably more noticeable given that both the euro (-16.4%) and the pound (-13%) are significantly undervalued vs the greenback when calculated using straight PPP.
CHART 1 – USD Index (1975 – to date)
Trump’s motivation is clear… a weaker dollar will help US exporters maintain a competitive stance in global markets. Given that he’s all about business and promoting US growth, his stance on the currency is hardly surprising. The question is, can he make it happen?
The simple answer to the question posed above is yes. Theoretically, weakening your currency shouldn’t be too difficult. Afterall, a central bank can print unlimited amounts of its currency and sell it – the Swiss National Bank managed to do it to halt the franc’s appreciation in 2012 through to 2015. In reality, there are a number of potential unwanted consequences, most notably inflationary pressures, a potential loss of confidence in the monetary system, not to mention a further escalation of trade tensions.
However, rather than the central bank acting, it would most likely be the US Treasury Department that intervenes by selling dollars. The Fed is likely to be anxious to protect its independence and hence may be unwilling to assist directly (although indirectly, it appears to be providing some support by adopting a more dovish stance on interest rates).
Since 1995, US officials are known to have intervened in the currency markets on three occasions although each has been a coordinated effort in conjunction with other major central banks to dampen excessive volatility. Emerging market Central Banks are constantly intervening (in both directions) to dampen volatility in their respective currencies. However, the ECB, BoE or BoJ are unlikely to be supportive of a move to weaken the dollar given that it would be to the detriment of their own economies / trade.
Moreover, whatever form the intervention may take, it may not be enough to offset the forces that have been driving the dollar higher. In a roundabout way, Trump is partly responsible here… all the talk of trade wars has been unsettling for markets and pushed investors towards safe haven assets (primarily US treasury bonds). Meanwhile, Trump’s fiscal stimulus efforts have fuelled growth and a subsequent rally in US equity markets, which in turn has attracted overseas investment.
If the dollar continues to strengthen, we see increased risk of intervention, most notably verbal intervention from Trump. For now, we think the probability of direct intervention from the Fed is small given its desire to remain independent, although we may well see Powell adopt an even more accommodative stance in due course. This may be enough to have a negative impact on the dollar in the short term, but it is unlikely to be long lasting.
We continue to keep a close eye on positioning data for signs that the major currencies are becoming oversold and thus vulnerable to a correction. This is certainly the case now with sterling and is also fast becoming so with the euro. From a longer-term perspective, valuation should not be ignored and provides justification for a bearish stance on the dollar. However, history has shown currencies can remain over / undervalued for an extended period and thus this isn’t something that can be relied upon from a short term perspective.