One of the most interesting and, for many observers, surprising market developments year-to-date has been the gradual descent of the broad trade-weighted U.S. dollar from the lofty 14-year highs reached late last year. Is this just a temporary lapse in a general dollar bull market, as most forecasters and market participants appear to believe, or has the dollar already peaked?
As always in currency space it’s hard to tell, but one thing is clear: The new U.S. administration is not interested in a strong dollar. Witness U.S. President Donald Trump’s comments that the dollar is “too strong” against the Chinese yuan and “it’s killing us” and White House trade advisor Peter Navarro’s recent allegations that Germany is using a “grossly undervalued” euro to “exploit” its trading partners.
These comments shouldn’t come as a surprise, at least not if you believe in my theory that we have entered a new “cold currency war.” Cold wars are not fought in open battle but with covert actions and words. In a PIMCO Blog post on currencies in December, I explained how the European Central Bank (ECB), the Bank of Japan (BOJ) and the People’s Bank of China (PBOC) opened the cold currency war through guarded actions that contributed to the depreciation of their currencies against the dollar during the second half of 2016. Yet, I also wrote that the U.S.’s “benign neglect seems unlikely to survive Trump’s first 100 days in office. A stronger dollar hurts the U.S. manufacturing sector and thus many of Trump’s voters. Continued dollar appreciation may make it (even) more likely that Trump will make good on his campaign promise and start targeting foreign currency ‘manipulators’ soon after taking office.” As Trump’s and Navarro’s recent comments show, benign neglect is now history.
Moreover, two other central banks seem to have entered the cold currency war last week, even if their statements are not primarily directed at their currencies. The Fed, in its post-FOMC meeting statement on Wednesday, refrained from trying to push the already low March rate hike expectations higher through more hawkish language. It was vindicated by a January labor market report on Friday that showed strong employment growth but easing wage pressures and a rising unemployment rate due to a jump in labor force participation. As a consequence, the probability of a rate hike in March priced into fed funds futures eased to only 15%. A day later, the Bank of England raised its GDP forecast in the quarterly Inflation Report but dropped its estimate of the NAIRU (the non-accelerating inflation rate of unemployment) significantly, thus sending a dovish signal that helped depreciate the pound.
So where do we go from here? In the logic of a cold war, it would now appear to be the turn of China, Europe and Japan to respond with covert actions that weaken their currencies again, or at least prevent them from strengthening further against the dollar. Yet, quite the opposite has happened recently: China fixed the yuan stronger against the dollar after the Lunar New Year, and the ECB has been quietly dropping hints that it may abandon the “downside risks to growth” language at its March meeting.
Perhaps this is just a temporary pause in the cold currency war. However, there is an alternative interpretation. Recall that a cold war requires a rough balance of power between the actors, where each side refrains from open warfare but at the same time dares to engage in a cold war because both sides have the (nuclear) ability to destroy the other. Without mutual deterrence, the weaker side won’t even dare to engage in a cold war, not to speak of an open war.
An end to mutually assured destruction
However, it can be argued that in this cold currency war there is no balance of power now that the Trump administration has taken office and appears to be much more willing to use the nuclear weapon: protectionism. With the U.S. running a large trade deficit and Europe, China and Japan having large bilateral surpluses with the U.S., the U.S. stands to lose much less (at least in its own perception) from a trade war, and the public pronouncements by Trump and Navarro suggest that protectionist action is a very credible threat.
If so, the rational response by Europe, Japan, China and other exporters would be to not overdo the cold currency war and, at least temporarily, allow some appreciation of their currencies versus the dollar in order not to provoke the U.S. further (hat tip to my esteemed PIMCO colleague Chris Dialynas, who has been making this point for some time). And recent actions or non-actions by the Chinese, Japanese and European side suggest that this may indeed be happening now. Whether this is enough to prevent the administration in Washington from pushing the nuclear tariff button remains to be seen. Time and tweets will tell.