Much of the world has been waging a cold currency war since the autumn of 2016, and so far the winner is Donald Trump. The dollar rally that followed the U.S. election is over, and this past week the U.S. Dollar Index (DXY, which tracks the dollar’s value versus a weighted basket of major currencies) sank to its lowest level in more than a year. While the U.S. administration and the Republican majority in Congress are yet to deliver on most of their policy goals, they have succeeded in making the dollar more competitive. How? By putting an end to the decades-long official mantra that “a strong dollar is in our interest” and by threatening other nations, implicitly and sometimes explicitly, with protectionist policies. In short, all this trade bullying has killed the dollar bull.
Monetary policy and exchange rates: a recent history
Back in December 2016, I argued that a new cold currency war had started, replacing the “Shanghai co-op” – the common understanding from February 2016 to stabilize the dollar. In the fall of 2016, the Bank of Japan (BOJ), the People’s Bank of China (PBOC) and the European Central Bank (ECB) all turned into cold currency warriors: The BOJ fixed the 10-year yield on Japanese government bonds at 0% at a time when global yields were rising, thus helping the yen to depreciate; the PBOC allowed the yuan to depreciate faster against the U.S. dollar; and the ECB introduced a “stealth rate cut” by removing the deposit rate floor of −0.4% for its bond purchases, which pushed European bond yields lower.
However, the Trump administration didn’t take long to fight back. A new phase in the cold currency war started early this year with President Trump, his trade advisor Peter Navarro and Treasury Secretary Steve Mnuchin all pushing back verbally against U.S. dollar strength and issuing veiled threats of protectionist actions. Since then, China has stabilized 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. And with the dollar sinking in response, the Trump administration has had no reason to turn aggressively protectionist. Mission accomplished.
What’s next for major currencies?
Has the U.S. dollar’s depreciation now gone too far, and will Japan and Europe start to fight back? Clearly, both yen and euro appreciation have been unwelcome given global lowflation pressures. Last week, the BOJ had to revise down its inflation forecast yet again, despite a decent economic recovery. And ECB President Mario Draghi noted in Thursday’s press conference that the euro’s appreciation had “received some attention” in the council’s discussions. Yet, markets were not impressed and pushed the euro to a two-year high against the dollar, which in turn hurt European equities, with the export-heavy German DAX Index falling to a three-month low.
However, despite the headaches that a weak dollar is causing for the ECB and the BOJ, 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 U.S. 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.
Two potential catalysts could reverse dollar’s trend, but neither is likely
Given that the trend is usually your friend in the FX market and that ECB or BOJ pushback to further appreciation is unlikely, what else could stop further dollar weakness? Two possibilities spring to mind.
First, a more hawkish Fed than markets currently expect might do the trick. However, this looks unlikely for now because unexpectedly low inflation and the Fed’s desire to start the balance sheet run-off soon mean that further rate hikes will likely be put on hold at least until December, if not for longer.
The second possible catalyst for a turnaround in the dollar is U.S. fiscal policy: If Congress and the Trump administration somehow manage to make progress in the next few weeks or months toward a credible plan for tax reform and/or significant tax cuts, the dollar would benefit, especially as expectations for meaningful fiscal changes have largely evaporated. However, at PIMCO we generally remain skeptical that either meaningful tax reform or large tax cuts will be enacted anytime soon – as we see it, there is only about a 50/50 chance of a small tax cut being enacted sometime in the first half of 2018.
All said, the Trump administration appears to be winning the cold currency war. To be sure, this is painful for European and Japanese exporters and stock markets and could well frustrate the ECB’s and the BOJ’s attempts to bring inflation closer to target. However, the alternative to a weaker dollar – i.e., protectionist policies by the Trump administration that could spark a trade war – would surely be even worse. The path of least resistance remains for a weaker dollar.
For insights into how key policy pivots could affect economies and exchange rates over the long term, please read PIMCO’s 2017 Secular Outlook, “Pivot Points.”
Joachim Fels is PIMCO’s global economic advisor and a regular contributor to the PIMCO Blog.