The Trump administration may have little to show in the way of legislative success, but one key area where it can book a victory is in exchange rates, Pimco says.
“Much of the world has been waging a cold currency war since the autumn of 2016, and so far the winner is Donald Trump,” Joachim Fels, the bond giant’s global economic adviser, writes in a blog post.
Overnight, the US dollar index – which tracks the greenback against a basket of major currencies – slid to its lowest level in 14 months, showing the US dollar rally that followed the American election is well and truly history.
The Aussie shot through US80¢ for the first time in more than two years overnight, while the euro has risen more than 10 per cent against the greenback this year.
That’s seen as mainly due to sinking US rate rise expectations amid dwindling inflation, while uncertainty surrounding the Trump administration’s ability to push through its pro-growth economic plans like tax cuts and infrastructure spending is also weighing on sentiment.
But Fels sees a more fundamental reason for the decline: both the White House and US Congress have moved away from the decades-long official mantra that “a strong dollar is in our interest”, he says, while at the same time threatening other nations, implicitly and sometimes explicitly, with protectionist policies.
“In short, all this trade bullying has killed the dollar bull,” he says.
Fels argued last December that a “new cold currency war” had started as some of the world’s major central banks introduced policies to push their exchange rates lower.
The Bank of Japan (BoJ) fixed the 10-year yield on Japanese government bonds at 0 per cent at a time when global yields were rising, thus helping the yen to depreciate; the People’s Bank of China allowed the yuan to depreciate faster against the US dollar; and the European Central Bank (ECB) introduced a “stealth rate cut” by removing the deposit rate floor of −0.4 per cent for its bond purchases, which pushed European bond yields lower.
The result, in combination with Trump’s pro-growth talk, pushed the US dollar higher against these currencies.
But things started to change earlier this year when the Trump administration decided to fight back, Fels says.
Key officials ramped up the rhetoric, pushing back verbally against US dollar strength and issuing veiled threats of protectionist actions.
Since then, Fels notes, China has stabilised the value of the yuan, the BoJ has kept policy on hold and the ECB has removed its easing bias and is inching closer to tapering its bond purchases.
“With the US dollar sinking in response, the Trump administration has had no reason to turn aggressively protectionist. Mission accomplished,” Fels says.
Hard to push back
The question for Fels is whether the US dollar depreciation will lead to a fightback by the ECB and BoJ, which can’t be happy with the strengthening of their currencies as they try to bolster growth with their low-rates policies.
Last week, the BoJ revised down its inflation forecast yet again, despite a decent economic recovery. And ECB President Mario Draghi noted in last Thursday’s press conference that the euro’s appreciation had “received some attention” in the council’s discussions.
Despite the headaches that a weak US dollar is causing for the ECB and the BoJ, Fels reckons it is difficult to see them pushing back aggressively.
“Outright intervention in the FX (foreign exchange) market is a no-go as it would likely spark protectionist retaliation by the US administration. Cutting already negative policy rates further is also unlikely, especially as the ECB only recently removed its bias to cut rates further.
“And delaying a further tapering of the ECB bond purchases much beyond the beginning of 2018 would be difficult given the self-imposed constraints on the purchase program (such as issue and issuer limits and buying according to the capital key), which imply that the ECB will be running out of bonds to buy.”
That means it would need either a more hawkish Fed or a legislative breakthrough on tax reform in Congress to trigger a turnaround in the US dollar.
But slow inflation stands in the way of the former, Fels says, and he remains sceptical on the latter, seeing a just 50-50 chance of a small tax cut in the first half.
“The path of least resistance remains for a weaker US dollar.”