President Donald Trump has opened a new front in the cold currency war: He recently complained in an interview and on Twitter that the strong U.S. dollar puts the U.S. at a disadvantage and that China and the European Union have been manipulating their currencies and interest rates lower. Moreover, for the first time since taking office, the U.S. president openly criticized the Federal Reserve for tightening monetary policy, claiming that this “hurts all that we have done.” The greenback obliged and weakened against most currencies after his tweets on 20 July.
Could this mark the end of this year’s dollar appreciation and the beginning of a new phase of dollar weakness?
Supporting factors for the dollar
A new dollar downtrend is possible, as last year’s dollar depreciation and the recent knee-jerk reaction demonstrate, because currency markets seem to take verbal intervention from the U.S. administration seriously. An initial market move caused by, say, a series of presidential tweets could become a self-sustaining trend given that exchange rates are often influenced by fashions and momentum models.
However, we think further dollar appreciation in the coming months is more likely for many reasons.
1. Unlike early 2017, when comments by President Trump and U.S. Treasury Secretary Steven Mnuchin sent the dollar on a path lower, the greenback doesn’t look excessively strong right now. Despite a 6% appreciation since its February 2018 trough, the dollar index (DXY) remains 8% below its December 2016 peak.
2. Growth rates differ: Last year’s dollar depreciation was helped by the rest of the world playing growth catch-up with the U.S. This year, the U.S. is likely to keep growing strongly due to fiscal stimulus, while China’s economy has been slowing and growth in the eurozone has shown only tentative signs of stabilizing after a sharp slowdown, albeit from lofty levels, during the first half of this year.
3. The Fed is likely to remain undeterred by the president’s verbal attack and keep marching up its own “appropriate policy path” dot plot. The Fed’s independence can only be repealed by an act of Congress, where there would likely be no majority for such a dramatic experiment, and Fed Chair Jerome Powell and the Federal Open Market Committee will be keen to avoid any semblance of yielding to complaints from the White House. As a consequence, the rate differential between the U.S. and other developed economies is likely to widen further, lending support to the dollar.
4. China looks likely to continue easing liquidity in an attempt to smooth the deleveraging process and support its economy and asset markets. This suggests further downward pressure on the yuan versus the dollar. While the Chinese authorities will probably want to avoid a sharp and abrupt currency depreciation, which would provoke the U.S. administration further, more yuan depreciation should be expected.
5. Last but not least, trade tensions between the U.S. and other countries are likely to continue in the run-up to the November U.S. midterm elections, as polls suggest that President Trump’s tough rhetoric is very popular with the Republican base. The threat of tariffs on an additional $200 billion of imports from China and the threat of a 25% tariff on all imported autos and parts are real and will likely lead to more volatility in financial markets in the coming weeks and months. Rising risk aversion typically supports U.S. assets relative to foreign assets, including the dollar against most currencies. (A notable exception is the yen.) Also, while there are no winners in a full-blown trade war (if it should come to pass), the U.S. stands to lose less than countries with large trade surpluses, which should also support the dollar.
So while President Trump’s re-entry into the cold currency war and his inclusion of the Fed on his list of targeted adversaries could possibly initiate a dollar downtrend, the strong countervailing trends suggest a more likely outcome is further appreciation of the greenback during the remainder of this year.
Joachim Fels is PIMCO’s global economic advisor and a regular contributor to the PIMCO Blog.
© PIMCO
© PIMCO
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