President Donald Trump has opened a new front inthe cold currency war: He recently complained in an interview and on Twitter that the strong U.S.dollar puts the U.S. at a disadvantage and that China and the EuropeanUnion have been manipulating their currencies and interest rates lower.Moreover, for the first time since taking office, the U.S. presidentopenly criticized the Federal Reserve for tightening monetary policy, claiming that this “hurts all that we have done.” Thegreenback obliged and weakened against most currencies after his tweets on20 July.
Could this mark the end of this year’s dollar appreciation and thebeginning of a new phase of dollar weakness?
Supporting factors for the dollar
A new dollar downtrend is possible, as last year’s dollar depreciation andthe recent knee-jerk reaction demonstrate, because currency markets seem totake verbal intervention from the U.S. administration seriously. An initial market move caused by, say, a series of presidential tweetscould become a self-sustaining trend given that exchange rates areoften influenced by fashions and momentum models.
However, we think further dollar appreciation in the coming months is more likely formany reasons.
1. Unlike early 2017, when comments by President Trump and U.S. TreasurySecretary Steven Mnuchin sent the dollar on a path lower, the greenback doesn’t look excessively strong right now.Despite a 6% appreciation since its February 2018 trough, the dollar index(DXY) remains 8% below its December 2016 peak.
2.Growth rates differ: Last year’s dollar depreciation was helped by the rest of the worldplaying growth catch-up with the U.S. This year, the U.S. is likely to keepgrowing strongly due to fiscal stimulus, while China’s economy has beenslowing and growth in the eurozone has shown only tentative signs ofstabilizing after a sharp slowdown, albeit from lofty levels, during thefirst half of this year.
3. The Fed is likely to remain undeterred by the president’s verbal attackand keep marching up its own “appropriate policy path” dot plot. The Fed’s independence can only be repealed by an act of Congress, wherethere would likely be no majority for such a dramatic experiment, and FedChair Jerome Powell and the Federal Open Market Committee will be keen toavoid any semblance of yielding to complaints from the White House. As aconsequence, the rate differential between the U.S. and other developedeconomies is likely to widen further, lending support to the dollar.
4.China looks likely to continue easing liquidity in an attempt to smooth thedeleveraging process and support its economy and asset markets.This suggests further downward pressure on the yuan versus the dollar.While the Chinese authorities will probably want to avoid a sharp andabrupt currency depreciation, which would provoke the U.S. administrationfurther, more yuan depreciation should be expected.
5.Last but not least, trade tensions between the U.S. and other countries are likely tocontinue in the run-up to the November U.S. midterm elections,as polls suggest that President Trump’s tough rhetoric is very popular withthe Republican base. The threat of tariffs on an additional $200 billion ofimports from China and the threat of a 25% tariff on all imported autos andparts are real and will likely lead to more volatility in financial marketsin the coming weeks and months. Rising risk aversion typically supportsU.S. assets relative to foreign assets, including the dollar against mostcurrencies. (A notable exception is the yen.) Also, while there are nowinners in a full-blown trade war (if it should come to pass), the U.S.stands to lose less than countries with large trade surpluses, which shouldalso support the dollar.
So while President Trump’s re-entry into the cold currency war and hisinclusion of the Fed on his list of targeted adversaries could possiblyinitiate a dollar downtrend, the strong countervailing trends suggesta more likely outcome is further appreciation of the greenback duringthe remainder of this year.
For more on our currency views, see related content on the PIMCO Blog.
READ NOWJoachim Fels is PIMCO’s global economic advisor and a regular contributor to the PIMCO Blog.