Currency Wars Ahead?

6 August 2019

The US Federal Reserve’s recent decision to reduce interest rates a stingy 25bp, and to deliver a less-dovish-than-expected statement raises more questions than it answered. Was the rate cut a one-time adjustment to provide insurance against the prospect of weaker growth ahead? Did Chairman Jerome Powell react to White House pressure? If so, President Trump’s post-meeting Twitter barage suggests, the strategy failed. Or, more worringly, does the policy U-turn (recall the central bank was projecting a series of rate hikes only six months ago) reflect the Fed’s diminished confidence in its ability to project the economy’s reaction to policy adjustments in the wake of the Global Financial Crisis? Whatever the answer, Chairman Powell’s messaging needs improvement. And, the Fed’s strategy has led to further US dollar appreciation — to the chagrin of the White House.

Meanwhile, following failed Sino-US trade talks in Shanghai, President Trump announced a 10% tariff on remaining Chinese imports (in addition to the existing 25% charge on $250 billion of goods). China has retaliated by allowing its currency to depreciate beyond the symbolically important CNY/$ 7 level.

Likewise, Boris Johnson’s selection as UK Prime Minister has increased the likelihood of a Hard Brexit. As a result, sterling has been pounded!

As all these sharp currency movements are the result of recent, overt policy decisions, are they harbingers of coming currency wars? Perhaps not wars, but skirmishes and volatility lie ahead.

US Dollar: Fed and White House on a Collision Course

The US dollar’s recent performance has been driven by two major themes. On the one hand, mounting twin trade and budget deficits point to a weaker exchange rate. Meanwhile, more resilient US economic growth compared to the rest of the world supports a stronger greenback. The recent release of US Q2 GDP data highlights key shifts in the composition of American economic activity. First of all, reflecting the impact of the tradewar, the chart above reveals that output growth slowed from 2.7% to 2.3% (YOY basis), led by a sharp decline in exports and a deceleration in capital spending. On the other hand, strong employment and income growth continued to produced bouyant consumer spending. All told, the Chart illustrates that despite some deceleration, final sales to domestic purchasers — which excludes the impact of exports and inventory swings — remains fairly resilient.

The Fed’s decision to reduce interest rates, but to curb expectations of further cuts, was an attempt to balance evidence of a weakening trade/manufacturing sector and a resilient consumer/service area. Meanwhile, the second Chart illustrates the continued evidence of weak economic activity in Europe and Japan. Indeed, ECB President Trichet outlined recently that Europe’s manufacturing sector, especially in Germany, remained weaker than expected. Consequently, the ECB and probably the Bank of Japan are likely to implement additional monetary stimulus in the period ahead. The continuation of desynchronised global growth will continue to be the prevailing driver of US dollar appreciation in coming months.

With the tradewars taking a toll on the US economy, surely America’s external imbalance will eventually undermine the US dollar? Indeed, the Trump Administration has often stated a preference for a weaker greenback. Indeed, despite the President’s aggressive trade policy, America’s global deficit continues to widen. To be sure, the Chart above indicates that tariffs have depressed both American exports and imports with China. However, as a result of bouyant consumer spending emanating from America’s ballooning budget deficit, imports from the rest of the world continue to rise, and the global shortfall widens.

For now, cautious Fed policy and unsynchronised global growth will produce further US dollar appreciation, perhaps toward $/Euro 1.05. However, as US growth (especially exports) slows further, the White House will exert additional pressure on the US central bank to reduce interest rates again, especially in the runup to the 2020 election. At that stage, slower growth, expanding twin deficits, and American political uncertainty may begin to take a toll on the greenback.

China: No Quick Fix

In a recent blog, I warned not to expect a quick fix to the Sino-US trade dispute. In addition, one should not be surprised by China’s decision to allow the CNY to depreciate following President Trump’s decision to impose additional tariffs. Indeed, this is what normally happens when a country experiences a terms of trade shock (either through market or policy-driven price changes). In fact, should the United States continue to ratchet up these levies towards 25% as threatened, I would expect China to retaliate again.

However, the tradewar is taking a toll on both the USA and China. US exports declined 4% in June. In addition, US imports of Chinese goods are declining sharply (Chart above). However, as US consumer spending remains bouyant, purchases from other countries are rising — note Vietnam in particular. In other words, the tariffs are both diminishing commerce and diverting trade patterns.

Similar patterns are emerging in China. Overall, exports have declined 1% in 2019, with sales to the USA off 8%. However, the Chart above indicates China has successfully diverted sales to other countries to help cushion the blow. Likewise, imports from the USA are down sharply, but China has been able to find alternative suppliers, especially agricultural products from Canada, Brazil, and Australia.

As there are few winners in in a tradewar, it’s not surprising that most nations now are suffering as well. The Chart above illustrates the dramatic slowdown in exports from the trade-oriented Asian economies. This situation will deteriorate substantially further, if China pursues additional CNY depreciation. Many Asian currencies are informally linked to the US dollar, and would suffer deteriorating competiveness with China and in third markets.

Given the adverse market reaction to the recent escalation in the Sino-US trade dispute, I suspect President Trump will be reluctant to impose additional tariffs as threatened, especially as the US economy weakens further prior to polling day. However, China should be under no illusion. A strong consensus exists within the US — and globally — that China is not playing by the rules. Indeed, a Democratic victory next year might result in American-led efforts to form a world-wide, multi-lateral response to Chinese trade and investment practices.

UK Sterling: Pounded!

The UK pound has fallen sharply, as the selection of Boris Johnson as the new Prime Minister increases the likelihood of a No Deal Brexit (see my earlier blog for a detailed assessment of that outcome). However, it’s likely that sterling would decline further if the UK leaves the European Union in a disorderly manner.

The Chart above illustrates the responsiveness of UK exports to currency weakness is limited. One explanation is that the UK’s participation in pan-European supply chains has reduced the price sensitivity in the trade of manufactured goods and parts, at least in the short run. Indeed, after a boost following the post-referendum devaluation, UK export growth has been modest: foreign sales volumes are up less than 1% during the past year.

More worrisome, however, is the UK’s productivity gap relative to its trading partners (Chart above). Of course, lowering the real FX rate enough will elimate this gap, but the required decline may need to be larger than expected.

While pundits debate Brexit’s long-term economic consequences, what is undeniable is that UK capital spending already has lagged far behind key trading partners since the 2016 referendum (Chart above). Weak investment, especially if continued post-Brexit, will contribute further to the UK’s efficiency shortfall.

The political outcomes remain hard to predict: Hard Brexit, Parliamentary revolt, General election are all possible. The likelihood of a negotiated deal with the EU, however, seems increasingly remote. No one like to say it out loud, but the UK must choose between remaining in the EU customs union (either for the entire UK or just for Northern Ireland) or violating the Good Friday Agreement. A No Deal result, which is the likely outcome, is just another name for the latter.

What are some market consequences? The Bank of England is quite likely to reduce interest rates before the end of the year, the timing will be determined by the scale of the expected fiscal stimulus. Currently, the UK current account deficit stands near 4% of GDP. The poor investment environment already has made financing the shortfall problematic. Consequently, a disorderly Brexit will lead to additional sterling weakness, even though the pound is already significantly undervalued (next Chart). Eventually, the UK will need to negotiate a new trading relationship with the European Union (regardless of the type of Brexit in October). The EU will not be indifferent to sterling’s deep discount.

Strategic Considerations:

  • The US dollar is overvalued (Chart above). Nevertheless, desynchronised growth, a cautious Federal Reserve, and additional monetary stimulus in Europe and Japan could lead to further appreciation towards $/Euro 1.05.
  • The Trump Administration prefers a weaker dollar. As the US economy and exports slow, President Trump will pressure the Fed to ease futher. I expect another rate cut by the end of the year, and another in H1 2020.
  • Given the market and economic consequences, I do not expect additional tariffs on China this year (beyond those implemented in September). Nevertheless, I expect the RMB to settle in a CNY/$ 7-7.4 range. The top of the range could be tested as it becomes evident that any Sino-US trade deal will take years to negotiate.
  • As many Asian currencies are linked to the USD, additional CNY weakness will hit regional currencies, INR, PHP, TWD, and THB may be vulnerable.
  • A disorderly Brexit will lead to additional monetary and fiscal stimulus. The Chart illustrates that sterling is already very undervalued. Nevertheless, it is not out of the question that the pound reaches $1.11 and Euro 1.05.
  • Heightened FX volatility and weaker global growth may be an additional pothole for world-wide equity markets in the period ahead, although additional monetary stimulus may provide an offst.