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GLOBAL MACRO RESEARCH CURRENCY DEVALUATION AS A POLICY TOOL
DECEMBER 2019
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Is currency intervention returning as a tool to help countries stimulate growth?
In the case of the US, some policymakers are considering currency devaluation as an economic stimulus tool for the first time this century.
The US administration is concerned about its widening trade deficit, and the arguable overvaluation of the US dollar is a barrier to closing it.
However, we believe it is highly unlikely an intervention would succeed in significantly lowering the value of the US dollar in the medium term. Even if successful, it would likely fail to narrow the trade balance. Instead, we believe it would materially risk sparking a ‘currency war’ between the US and its peers.
As such, we see a low but not insignificant probability that the US will intervene in currency markets within the next year. However, it may become harder to rule out intervention over the longer term, particularly as both Republicans and Democrats are showing greater appetite to weaken the dollar going into the 2020 presidential election. WHY MIGHT THE US PURSUE A WEAKER DOLLAR?
FOR THE FIRST TIME IN THE 21ST CENTURY, US POLICYMAKERS ARE SERIOUSLY CONSIDERING MEANINGFULLY INTERVENING IN THE CURRENCY MARKETS.
WHY HAVE COUNTRIES BACKED AWAY FROM ATTITUDES TO INTERVENTION ARE REACHING CURRENCY INTERVENTION? AN INFLECTION POINT
The US developed an increasingly ‘laissez faire’ attitude to However, globalization and trade liberalization are now facing a currency markets in recent decades – very much in line with the domestic political backlash given factors such as inequality, a emergence of globalization and the increasingly liberalized perception of Chinese theft of US intellectual property and a economic world order that emerged from the 1970s (when widening US trade deficit (Figure 1). currencies first became free floating). Narrowing the US trade imbalance (by encouraging the growth of The rise of complex global supply chains and international exports relative to imports) has become a clear goal of the portfolio flows had left policymakers increasingly concerned with administration. Political trends are now therefore increasingly the ineffectiveness of currency intervention. focused on protectionism. However, a major hurdle remains – an arguably overvalued US dollar. As such, currency devaluation is once again being eyed as a potential policy tool.
Figure 1: The widening US trade balance has become a political issue1
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1 Source: Bloomberg, September 2019. 3 THE USD IS UNLIKELY TO DEPRECIATE WITHOUT DIRECT INTERVENTION
The US dollar (USD) currently looks expensive compared to peers such as the euro and sterling – at least on a purchasing power parity (PPP) basis. In general, if not outright expensive, it at least A global slowdown appears to be the ‘least cheap’ it has been for 17 years (Figure 2). Figure 2: the USD looks overvalued against most core currencies would actually likely on PPP (A negative reading suggests the USD is overvalued)2
place upward pressure 0.15 0.10 on the currency as 0.05 -0.00 the USD is required to -0.05 -0.10 PPP valuation -0.15 purchase the ultimate -0.20 global safe-haven assets JPY/USD SEK/US D EUR/USD GBP/US D NZD/US D CAD/USD NOK/US D – US Treasuries. AUD/USD
2 Macrobond, November 2019. 4 MEDIUM-TERM CURRENCY DRIVERS
Will the USD weaken without an intervention? It would appear unlikely if we look at the two empirical drivers of medium-term exchange rates3:
INTEREST RATE DIFFERENTIALS4 THE USD’S ‘SAFE-HAVEN’ STATUS Driver 1 Driver 2 Unlikely to sufficiently ease A structural barrier
What is the potential for US yields to contract relative to their peers? Even if we were to assume that the Fed were to be forced to cut rates to defend a faltering US economy – the other important If 5-year US yield spreads, relative to other countries, were to empirical driver is the safe-haven status of US dollar (Figure 4). tighten by 1%5 historical data implies USD would likely depreciate by almost 7%6 (Figure 3). Figure 4: An increase in the G10 currency volatility index of one Figure 3: Average beta of changes in USD (versus major developed has led, on average, to a ~0.3% appreciation in the USD8 market currencies) to changes in relative 5-year yields7 0.7 8 0.5 7 6.73 6 0.3 0.34 5 Beta 0.1 4
Beta 0 3 -0.1 2 1 -0.3 2004 2006 2008 2010 2012 2014 2016 2018 0 1995 2000 2005 2010 2015 Average beta of USD vs G10: change in currency versus change Average beta of USD vs G10: change in FX vs Ch in 5-year yields in G7 Volatility Index
As an example, the current difference between US and European A global slowdown would likely place upward pressure on the 5-year yields is around 2%, so US yields may ideally need to at least currency as the USD is required to purchase the ultimate global converge toward Europe for a material USD depreciation. safe-haven assets – US Treasuries.
Is that realistic? The main factor in the US administration’s favor is Even in the case of a hypothetical US-only economic slowdown, that rates may be close to their lower limits in core Europe, but the depreciation may be limited by the tendency of US investors to Federal Reserve (Fed) would still likely need to embark on an ‘export’ less capital than their peers during bouts of volatility, aggressive rate-cutting cycle. partly given the size and depth of their domestic market.
For this to occur amid the normal course of monetary policy, the US economic and inflation outlook would need to materially deteriorate without somehow also inflicting commensurate pain on its global peers (which is unlikely in an increasingly globalized world).
3 The drivers of longer-term exchange rates are different than the medium-term drivers. Long-term exchange rates tend be driven by long-term productivity, as highlighted by the literature around Behavioural Equilibrium Exchange Rate models (BEERs). Here, we are concerned with medium term. 4 The relationship between interest rate differentials and free floating exchange rates is well established (when countries primarily use monetary policy to manage their business cycles. The intuition behind this is that interest rate spread changes can approximate the relative position of each country within its respective economic cycle. 5 Equalling its all-time low set in summer 2012. 6 One of the questions that has been raised recently is: do unconventional monetary policy (UMP) tools like quantitative easing (QE), forward guidance, and yield curve control have a separate impact to interest rates? If so, it would be difficult to empirically disentangle those effects. We do not see this as a concern, however. We believe that UMP influences currencies through interest rate movements. This was underscored when the European Central Bank (ECB) restarted QE on September 12, 2019. It caused 5-year bund yields to sell off relative to 5-year Treasury yields. Subsequently, the EUR/USD also rallied. 7 Source: Bloomberg. 8 Source: Bloomberg, November 2019. 5 POLITICAL APPETITE FOR USD INTERVENTION IS RISING
ABSENT A USD DEPRECIATION THROUGH MARKET FORCES OR NORMAL MONETARY POLICY CYCLES, IT IS NOT DIFFICULT TO SEE WHY POLITICAL WILL IS BUILDING FOR MORE DIRECT CURRENCY INTERVENTION.
US FINANCIAL CONDITIONS WOULD LIKELY REPUBLICANS AND DEMOCRATS ARE BOTH IMPROVE IF THE CURRENCY WEAKENED INTERESTED IN A WEAKER DOLLAR
Insight modelled the potential impact of a lower USD on financial President Trump has admonished the USD’s value on a number of conditions, through three currency scenarios (Figure 5), examining occasions, complaining of a “big disadvantage” against Europe10 USD depreciations of -4% and -8% and a rise of 4%. while stating the US should match China’s and Europe’s “currency manipulation game”11. The result indicates financial conditions in the US would loosen – which would have positive implications for US financial markets However, the President is not the only policymaker in Washington and US GDP. seeking a lower USD. In late July 2019, a Democrat (Senator Baldwin from Wisconsin) and a Republican (Senator Hawley from Figure 5: US Financial Conditions Index9 Missouri) introduced “The Competitive Dollar for Jobs and Prosperity Act”. -2.0 Looser -1.48 The bill would charge the Fed with “achieving and maintaining the -1.0 -1.14 current account balance”, charging “a variable rate fee” on -0.51 incoming capital and authorize the Fed to “neutralize exchange 0.0 0.16 Beta rate manipulation by other governments”12. 1.0 We see this bill as unlikely to pass – as taxing capital inflows would Tighter 2.0 likely be substantially negative for global growth and financial 2016 2017 2018 2019 markets. However, a weaker USD appears to be emerging as a Financial conditions index $ -4% $ -8% $ +4% bipartisan issue heading into the 2020 US presidential election.
However, when running the impact of these USD scenarios on UK, Eurozone and Japanese financial conditions, we found a material tightening (i.e. negative) impact.
Therefore, a cheaper USD would likely help the US, but materially hurt its peers.
9 Source: Insight, November 2019. For illustrative purposes only. Based on Insight proprietary model. Where model or simulated results are presented, they have many inherent limitations. Model information does not represent actual trading and may not reflect the impact that material economic and market factors might have had. Information does not reflect actual trading for portfolios managed by Insight. The index consists of assumptions around three components: US policy rate, global corporate bond spreads and global equity market performance. Each of the three US exchange rate scenarios is overlaid. 10 Twitter, June 11, 2019. 11 Twitter, July 3, 2019. 12 According to the lobbyist group “A Coalition for a Prosperous America”. 6 WHAT WOULD THE US NEED TO SUCCESSFULLY WEAKEN THE DOLLAR?
WE SEE THREE FACTORS THAT WOULD BE ESSENTIAL (BUT NOT NECESSARILY SUFFICIENT) FOR INCREASING THE CHANCE OF A SUCCESSFUL CURRENCY INTERVENTION.
US TREASURY AND FED CURRENCY INTERVENTION COORDINATION WITH CORE 1 NEED TO COOPERATE 2 IS UNSTERILIZED 3 COUNTRY CENTRAL BANKS (Possible) (Not a given) (Close to impossible)
The Treasury has paltry resources for By ‘printing’ USD to buy other currencies, An attempt at devaluation is likely to be currency intervention – at about 0.35%13 the Fed would increase the money supply. ineffective if other central banks simply of the $6.6trn of global currency that All things being equal, this would put defended their currencies in response. trades daily (88% of which has a USD leg). downward pressure on relative USD The US would simply start a ‘currency Undoubtedly, it needs to work with the market interest rates, which would likely war’ (or ‘competitive devaluation’) in this Fed, which can simply ‘print’ dollar depreciate the currency. scenario. To succeed, other core country reserves to buy other currencies. central banks would therefore need to However, if it ‘sterilizes’ the intervention help the US devalue, as they famously did The Fed would need to extend its easing through offsetting Open Market during the 1985 Plaza Accord14. cycle and jointly intervene in currency Operations (as it has often done) we markets to uphold its end of the bargain. believe it would likely be a wasted effort However, today, core country central However, while the Fed has historically outside of the very short term. banks are mostly focused on keeping tended to join the Treasury, it has no legal their currencies competitive to foster obligation to. domestic growth and inflation. As our analysis shows, financial conditions outside the US would be hurt by a weaker USD; the other nations have little incentive to cooperate.
DOES EVIDENCE INDICATE THAT INTERVENTION CAN EVEN WORK AT ALL?
Even assuming the three conditions are met, the bad news for cutting cycle in 1986. Similar can be said of the Reserve Bank of the US administration is there is still very little evidence that Australia’s 2008 intervention, which coincided with US and currency intervention can even work in the first place. Chinese fiscal stimulus measures and the passage of the US’ troubled asset relief programme (TARP). Causation is therefore Some recent studies have shown a success rate of around 60%, hard to prove. but crucially only examine the impact during the intervention and not in the medium or long term15. For this, we are forced to Ultimately – this leaves us highly skeptical that policy action has turn to historical anecdotes, but these tend to offer even less much hope of pushing the USD meaningfully lower in a comfort. sustained fashion.
The Plaza Accord, for example, preceded a 19% depreciation of the USD – but it also coincided with an aggressive US rate-
13 According to the latest financial statement as of late August 2019.14 The Plaza Accord was a 1985 agreement between the United States, the United Kingdom, France, Germany, and Japan to manipulate exchange rates by depreciating the US dollar relative to the Japanese yen and the Deutsche mark. 15 Fratzscher, M., Gloede, O., Menkhoff, L., Sarno, L., and Stoehr, T., (2018) “When Is Foreign Exchange Intervention Effective? Evidence from 33 Countries”, American Economic Journal: Macroeconomics. 7 WOULD A WEAKER USD EVEN MAKE A MEANINGFUL IMPACT ON THE TRADE BALANCE?
CORRECTING THE TRADE BALANCE COULD This is perhaps unsurprising given that US trade is a relatively BE A BRIDGE TOO FAR small proportion of GDP.
To achieve the US’ goal of achieving a positive trade balance, we Given the current trade balance is in deficit to the tune of 3.2% of believe that weakness in the US dollar would need to be GDP, this implies the USD would need to weaken by more than substantial and sustained. 100% to close the trade gap.
A recent study16 suggests a 10% USD depreciation would lead to a 0.2% of GDP improvement in the US trade balance (Figure 6).
...the USD would need to weaken by more than 100% to close the trade gap
Figure 6: The estimated impact of 10% USD depreciation on net exports is just 0.2% of GDP17
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Effect on net expor sensitive 0.0 IR L IS R FI N CR I IT A ID N IN D JP N BE L ES P CZ E NZ L ZA F PE R LKA PRT EG Y PHL FRA SG P CHL POL TUR RU S CO L CH E UR Y PAK GB R NL D GRC KOR BR A DE U HKG THA SA U AU T US A AU S AR G TUN DN K SW E CA N CH N NO R ME X HUN GTM MAR
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16 Bussiere, M., Gaulier, G., and Steingress, W., (2017). Global Trade Flows: Revisiting the Exchange Rate Elasticities. Bank of Canada Working Paper 2017-41. 17 Bussiere, M., Gaulier, G., and Steingress, W., (2017). Global Trade Flows: Revisiting the Exchange Rate Elasticities. Bank of Canada Working Paper 2017-4. 8 CONCLUSION US INTERVENTION IS UNLIKELY OVER THE NEXT YEAR BUT CANNOT BE RULED OUT FOR THE FUTURE
PROBABILITY OF FAILURE LIKELY TOO HIGH FOR POLICYMAKERS
Overall, we believe that the likelihood of a US currency intervention is low but not insignificant but we believe offers little realistic prospect of success, outside of a modest short-term depreciation.
Furthermore, an intervention would likely be seen as a ratcheting up of trade tensions abroad, and will likely tighten financial conditions outside the US, potentially triggering a ‘currency war’ and fracturing trading relationships further.
THE ADMINISTRATION WILL LIKELY KEEP TARIFFS GOING AND WILL MAINTAIN PRESSURE ON THE FED
For now, we believe the US administration’s path of least resistance will be to continue to pressure the Fed to lower rates while maintaining its current protectionist stance on global trade. Closing the trade balance would realistically likely require a period in which global growth is much stronger than the US, which appears unlikely in the shorter term.
DON’T RULE OUT CURRENCY INTERVENTION AFTER THE ELECTION
Looking ahead, however, intervention cannot be ruled out. We believe the trade war marks a new era in US political and economic strategic priorities, one that likely reflects a secular tipping point. Regardless of the outcome of the 2020 election, we believe policymakers may be all the more likely to view the USD as a potential policy tool in the coming years.
9 CONTRIBUTORS
Francesca Fornasari, Rory Stanyard , Head of Currency Solutions, Currency Analyst – Global Rates, FIG, Management Group, Insight Investment Insight Investment
Isobel Lee, Amol Chitgopker, Head of Global Fixed Income Bonds, Senior Investment Content Specialist, Fixed Income, Insight Investment Insight Investment
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