Earlier this year, we saw a transition from an old-style currency war (openly fought with negative interest rates and quantitative easing) to the “Shanghai co-op” – an implicit agreement, or truce, among major central banks that excessive dollar strength was bad for the global economy. As a consequence, the Federal Reserve became more dovish, the European Central Bank (ECB) and the Bank of Japan (BOJ) de-emphasized negative interest rates, and the stabilization of the U.S. dollar helped emerging markets and commodity prices recover. Also, China’s depreciation of the yuan was orderly rather than disruptive.
With Donald Trump’s election as U.S. president, we have entered a new phase that I call a “cold currency war.” It’s a cold war because central banks are fighting in a more guarded way.
- Even before the U.S. election, Japan was moving subtly in the direction of further currency depreciation. By pinning the 10-year Japanese government bond yield near 0% since September, the BOJ has managed to widen the yield differential between Japan and the rest of the world during the global rates sell-off of the past few months, which has beautifully depreciated the yen. Following the BOJ’s meeting this week, Governor Haruhiko Kuroda said it was too early to change that yield target and downplayed yen depreciation (noting it was only back to where it had started the year).
- The ECB implemented a “stealth rate cut” in early December by dropping the deposit floor for bond purchases, which helped to push the euro lower.
- The People’s Bank of China has stepped up the yuan’s depreciation versus the dollar since September. Beijing’s critical noises following the Fed rate hike in mid-December suggest we may see accelerated depreciation into the new year (remember last January?).
So, in effect, the n-1 currencies are now depreciating against the nth currency, the U.S. dollar.
So far, the issuer of the nth currency has shown benign neglect toward the dollar’s appreciation. In fact, the Fed effectively hiked rates not once but twice in December – once by raising the target for the fed funds rate by 25 basis points and once on paper by moving up the median “dot,” essentially forecasting more rate hikes than previously expected. And both the outgoing and incoming administrations have remained mum on dollar appreciation. The Trump camp perhaps sees it (along with the stock market rally) as a welcome vote of confidence.
However, this 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. If that happens, it could rattle risk assets, which are so far romancing the right-tail risk and downplaying the left tail (“more bark than bite”) following the U.S. election. This, in turn, would likely lead to a reassessment of the Fed’s rate path, which could be an escape valve for dollar pressure.
But these are the next possible battles in the new cold war. In the meantime, a restful holiday and a Happy New Year!
Joachim Fels is PIMCO’s global economic advisor and a regular contributor to the PIMCO Blog.