It is no secret that the U.S. administration wants a weaker dollar: It would make American exports more competitive and potentially boost growth. But would the U.S. cross into the world of currency intervention to make it happen?
President Donald Trump has claimed many times that China has unfairly manipulated its currency. Recently, he lashed out against the European Central Bank (ECB) for hinting at additional monetary policy stimulus because it might drive the euro lower against the dollar. Consequently, investors have become keenly attuned to the possibility of a shift in the strong dollar policy that has been in effect through several U.S. administrations.
Although Trump reportedly rejected one proposal to intervene in the currency market last week, the idea has clearly come under discussion within the administration amid trade frictions and slowing global growth. Indeed, Trump could possibly change to a stable dollar policy.
However, we think that intervening in currency markets to weaken the dollar is unlikely. These days, currency intervention by developed market governments is rare. Typically, it occurs only when markets become dysfunctional due to a significant event, such as Japan’s earthquake in 2011, or when the valuation of a major currency becomes so extreme that it creates a collective interest in reversing the trend.
In this context, the rationale for governments to weaken the U.S. dollar is lacking: The markets are functioning well, and while we estimate the dollar is about 10% overvalued relative to structural and fundamental macroeconomic factors, this is largely in line with past episodes when the U.S. economy has outperformed its peers.
Nonetheless, the market consequences of direct intervention by the U.S. could be substantial and thus bear consideration.
Credible currency policy
The Gold Reserve Act of 1934 gave the U.S. Treasury vast discretionary power in foreign exchange policy. Using the Exchange Stabilization Fund (ESF), Treasury can deal in gold, foreign exchange, and other securities as necessary to carry out this policy. Treasury does, however, face practical constraints, the most important being the limited size of the ESF, as without Congress it’s unlikely that the Treasury can issue more government debt to fund ESF foreign currency holdings.
For decades, the U.S. government has intervened in currency markets from time to time and achieved its goals without spending trillions of dollars. We attribute this relative success in large part to the credibility of the policy, which, critically, has relied on both central bank and international cooperation.
Two questions, then, are central to assessing the potential for U.S. currency intervention today. Would the Federal Reserve choose to participate alongside the U.S. Treasury? And would intervention garner support from the international community?
Traditionally, the Fed has intervened alongside the Treasury to help stabilize markets or to help correct an excessive move in exchange rates, typically matching Treasury intervention dollar for dollar. With the Treasury’s capacity to intervene in currency markets limited to the $95 billion in the Exchange Stabilization Fund (according to the last ESF financial statement), that implies a cumulative $190 billion potentially available for U.S. intervention if the Fed participates – an amount that is likely to fall short of the force required to sustainably weaken the dollar.
It becomes even more important, then, that the U.S. win cooperation from international peers. However, other developed market governments and international agencies largely discourage currency intervention by leading nations. And in the current environment of global trade frictions, intervention to competitively devalue the dollar is even more unlikely to gain their support.
Without international cooperation, U.S. currency intervention would probably be seen as a provocation and further exacerbate trade frictions. This would be particularly so if the intervention were targeted solely at the Chinese yuan rather than a set of major currencies. In the worst-case scenario, Washington would intervene following a currency depreciation by China in response to higher U.S. tariffs.
Implications for markets
In our view, if the U.S. were to intervene, it would be ineffective, even as a short-term palliative. We think markets would price in an increasing probability of other mercantilist U.S. policies, including more tariffs. In this scenario, developed market government bonds and other “safe-haven” assets (e.g., the Japanese yen and Swiss franc) should benefit while global equities would likely drop as uncertainty and recession risk increase.
A scenario of mildly effective currency intervention backed by the Fed is possible. This could create a constructive environment for investing in emerging market and commodity currencies. But without the blessing of global peers, intervention would increase uncertainty, and the negative consequences for global growth would outweigh any benefits to the U.S. from a softer dollar.
The bottom line
In sum, we think the likelihood of the U.S. government intervening in currency markets to weaken the dollar is low. But importantly, were it to occur, we are skeptical that it would drive down the dollar on a sustained basis. For the policy to be credible and effective, the U.S. government would need the coordination, or at least cooperation, of its international peers and the Fed.
For more on global trends and their impact on investing, please see “Secular Outlook 2019: Implications for Investors.”
Gene Frieda is a global strategist at PIMCO in London. Tiffany Wilding is a PIMCO economist focusing on the U.S.