Lessons in Foreign exchange

by George Hatjoullis

Periodically one hears politicians make statements about the value of the currency of their nation-state. Erdogan has lamented the weakness of the Turkish Lira and implied some conspiracy to undermine him through it. Everything Erdogan finds inconvenient seems to be a conspiracy against him. This is populism in action in case you still do not understand the term. Trump and his administration have given conflicting signals about the value of the USD and many words of digital newsprint have been devoted to this. The Trump administration has accused more or less every other large state (except the UK) of being a currency manipulator. In the past politicians have lamented ‘attacks’ on their currency. I recall Lamont and Soros in particular. This is all political spin and populist manipulation.

Currency markets are huge and single-minded. The ‘players’ have no political agenda. They are looking to make money. Moreover the power of governments to control currency values on a sustained basis is seriously limited. Political statements have a short-term effect because currency traders bear a striking resemblance to Pavlov’s dogs. They get under cover at the sound of thunder even when there is little chance of rain. In a world of independent central banks with an inflation target, currency values are an outcome of market forces. The US Federal Reserve has a dual target, price stability and employment, making the USD very definitely an outcome of market behaviour. Finally, the USD is a reserve currency and thus subject to huge portfolio flows that may be unrelated to trade. The USD value is an outcome. What the President says or does not say has no direct bearing on the value of the USD.

The President can however set policy to be consistent with a stronger or weaker USD. As I have already discussed in Trumpeting the US Dollar the promised easing of fiscal policy, combined with tightening of monetary policy is consistent with a stronger USD. So if Trump wants the USD weaker his alleged fiscal plans will not help achieve this. However, as I have also noted elsewhere, consistency is not prized by populists. The protectionist direction of policy is also consistent with a stronger US Dollar. Also significant might be the plan to force companies to repatriate tax shy cash held abroad, though this is only so if the cash is not already held as US Dollars offshore. Much of it probably is held as US Dollars offshore. The biggest influence is of course the reserve currency status of the USD. It is the ‘safe’, liquid asset of choice for other central banks. There is a natural demand. At a time when ‘safe’ liquid assets are at a premium it is not hard to see why depreciating the USD may prove difficult.

The reserve currency status comes with certain perks. It confers seigniorage on the US. Basically the US can exchange USD printed by the Fed for real goods and services. This is a kind of loan except the sellers will hold a significant proportion of these reserves as cash in perpetuity. It is a loan that has no repayment date and carries no interest. In order for the reserve currency to provide the necessary USD to the world to keep the monetary system functioning it must buy more than it sells. It must run a current account deficit. Lamenting the US current deficit is to deny the USD reserve currency role and the seigniorage it confers.

The reserve currency status may come under strain during the Trump era. It is not hard to see why some countries might prefer a different international money. Unfortunately there is no alternative at the moment. The euro would be a contender if it could integrate its capital markets but this is not imminent. It also speaks to my message in The Silver Lining in the Trump Cloud. This an opportunity for the EU to step up. Indeed, it must step up or face bad consequences. If the Trump regime follows through it could end the USDs reserve currency status and, in the absence of an alternative, fracture the global monetary system. Perhaps currency traders are not simply Pavlovian when they jump at thunder.

Currency values are of course relative. It is not just what Trump et al do that matters. It is relative policy regimes that matter. If the eurozone withdraws its easy money position and starts to embrace fiscal transfers then the EURUSD rate may jump sharply. Given the inflation trend there will be pressure from Germany on the ECB to raise rates and cut back its QE. There will also be pressure on Germany to resolve the eurozone crisis and embrace fiscal transfers. It is no longer simply the eurozone that faces an existential threat but the EU itself. It remains to be seen what the EU will do.

Japan is a textbook study of how not to run an economy. It has exhausted every conventional policy tool several times and still it cannot generate inflation. I predicted this as one of my first blogs and indeed many years ago in a professional context. It has one potential policy option. The BoJ can write off the government bonds it holds and the central bank can issue new debt and spend the money it raises. It seems unable to come to this decision.If the Trump era brings a contraction of world trade then one wonders how this nation that depends so much on foreign demand to keep functioning is going to fare. The only reason the Yen rallies when there is concern about the USD is because so much USD is held by Japanese entities. It is not really a safe haven but it is the safest place for Japanese entities. Unfortunately Yen cash yields very little and often costs the depositor so it is hard to sustain the demand for Yen. Japanese institutions must really dislike the USD to appreciate the Yen.

The Trump era looks set to change the global and political world order pretty damn quick. My own view is that these changes were coming and the final outcome was looking dark in the medium term under Clinton also. Trump may galvanise the likes of the EU and other smug, complacent liberal institutions into action and ultimately achieve a better outcome sooner. But these are dangerous times (we are well past ‘interesting’). Established asset relationships will break down as the political order morphs. For the moment the USD retains its ‘strong’ status and nothing much that Trump says or is likely to do will change this. However, this is not a time for strong convictions. It is a time to be nimble.