Winning the Cold Currency War

Investors in Europe are more optimistic than they have been in years thanks to a strong economy and buoyant markets. There is a fly in the ointment, however: a growing concern that continued U.S. dollar weakness could make the euro too strong, with negative consequences for corporate earnings and economic growth.

Indeed, why has the dollar weakened so much, and how much further can it go? And equally important, what are the consequences of a stronger euro for Europe?

The cold currency war

The dollar’s 10% decline against other major currencies in 2017 and the comment on 24 January by U.S. Treasury Secretary Steven Mnuchin at the World Economic Forum in Davos that a weak dollar is good for the U.S. in the short term all but confirm that the U.S. administration is engaged in what we have called a “cold currency war” – and it is winning.

Cold wars are not fought in open battle (for example, with currency intervention), but with words and covert actions. The words in the cold currency war have been loud and clear, but what is the covert action? We see a combination of recent actions: (i) a fiscal expansion at the wrong time of the economic cycle, financed mostly by additional Treasury debt, and (ii) a Federal Reserve that appears unwilling to respond with monetary tightening over and above what was already planned, while also discussing an inflation overshoot. These actions are sending an implicit but very clear signal to markets: A weaker dollar is the goal. Markets have understood the signal.

The reason the U.S. has gained the upper hand in this cold currency war is that the balance of power is asymmetric. U.S. President Donald Trump carries the bigger stick: the threat of protectionism. And so Europe and Japan have acquiesced; neither has stemmed their currencies’ appreciation with words or actions. On the contrary, both the European Central Bank (ECB) and the Bank of Japan have reduced the pace of their bond purchases, and the ECB has even been hinting at ending net purchases later this year.