19 Jul Be Careful What You Wish For; The Trade War with China*

Be Careful What You Wish For

President Trump wants the US Dollar to be weaker. He has browbeat told asked the Federal Reserve to lower interest rates so that the Dollar will become a less attractive valuable currency. Fed Chairman Jerome Powell has agreed to lower rates, though of course not because of pressure from the White House, because the Federal Reserve has concluded that the U.S. economy has weakened – trade conflicts and softening global growth have created “uncertainties” that require a Fed rethink.

Why does President Trump want a weaker US Dollar?

For Trump, it’s all about the U.S. trade deficit, which has expanded significantly over the past ~20 years. He’s made it a priority for his Administration to reduce it … and to do so with every one of America’s trading partners, particularly with China and the EU. He believes that his “Buy America” policies and confrontations with trading partners – through tariff wars and otherwise – over what he sees as economic distortions will shrink the trade deficit, create jobs, and strengthen national security. He also believes that, if the US Dollar is worth less relative to other currencies, foreigners will be more likely to buy more American goods and thereby boost U.S. manufacturing.

The substantial majority of economists disagree.

Consumers spend and import more when the Dollar is strong and goods are cheap … and higher U.S. interest rates have made foreigners eager investors in U.S. businesses and markets – cheaper goods and strong foreign investment in the U.S. are good things. A strong U.S. economy – which is another good thing – necessarily increases the trade deficit. The strong Dollar has made the U.S. the wellspring of global liquidity, which drives up demand everywhere, enhances the importance and profitability of U.S. markets, and entrenches the Dollar as the world’s reserve currency … requiring other countries to add US Dollars to their reserves – which is a further good thing. This, in turn, creates massive demand for U.S. financial assets, including U.S. government securities … precisely what America needs to fund its enormous budget deficits – the good things keep coming. This means that the U.S. is able to finance its high consumption at a low cost, which further boosts both Americans’ demand and the global economy by lowering prices and increasing productivity – even more good things! Each relies on the others in a self-reinforcing cycle.

A trade surplus often has the reverse effects …, although in a healthy global economy (which is not the case today) a trade surplus should indeed boost foreign demand for American goods and services.

As part of his campaign for a weaker Dollar, Trump not only has pressured the Fed for lower interest rates, he also has been raising tariff barriers and sanctioning foreign companies, presenting currency valuation as part of a war between trading nations, tweeting in recent weeks that “China and Europe [are] playing [a] big currency manipulation game and pumping money into their system in order to compete with USA…. We should MATCH, or continue being the dummies who sit back and politely watch as other countries continue to play their games – as they have for many years!” This was not Trump’s first attack on foreign currencies. Earlier in June he had tweeted: “Mario Draghi just announced more [European Central Bank] stimulus could come, which immediately dropped the Euro against the Dollar, making it unfairly easier for them to compete against the USA.”

Really? Was that truly the reason for the ECB’s change in policy … or was it because the European economy is in the process danger of falling into Recession?

The Dollar owes its relative strength to the sounder fiscal policies pursued by the Fed America after the Great Recession. Since Trump took office in January 2017, the Dollar has strengthened. It’s done so because of the Trump Administration’s pursuit of “America First” protectionist trade policies and its enactment of the huge fiscal stimulus of the 2017 Tax Cuts and Jobs Act …, as well as because of increases in interest rates necessitated by the economic growth created by the Trump Administration’s stimulative policies and engineered by the Fed. With the dominant U.S. economy as a global magnet for goods and services, and with U.S. government securities paying higher interest rates than all other fiscally stable developed countries, the Dollar naturally is the world’s strongest, most-attractive, most-used currency.

Presidents want a strong dollar, and for good reason. Except for the desire of virtually every President for low interest rates to stimulate economic activity, no President before Trump has advocated, or advocated so hard, for a weaker dollar. The strength of the Dollar anchors it as the world’s reserve currency … and the status of the US Dollar as the world’s reserve currency is what anchors the American economy. In a virtuous circle, the Dollar is the most significant contributor to America’s economic greatness. It comprises 62{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} of global central bank reserves; 65{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} of physical US Dollars are used outside the U.S.; 90{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} of foreign exchange trading involves the US Dollar; and one-third of the world’s Gross Domestic Product is generated by countries that peg their currencies to the US Dollar. The reason the U.S. economy remains the world’s strongest is because its currency is the world’s strongest.

The Trump Administration’s effort to weaken the US Dollar therefore has downsides … and threatens what is a delicate, market-driven economic balance.

Trump therefore should be careful what he’s wishing for … because he may actually get it. It may come, however, with unintended and unforeseen consequences. He appears to believe that his goal is simple, a modest weakening of the Dollar’s value: “I want a strong dollar, but I want a dollar that does great for our country, not a dollar that’s so strong that it makes it prohibitive for us to do business with other nations and take their business,” Trump said in June before criticizing Fed Chairman Powell.

It’s unclear whether such fine-tuning is attainable …, yet alone that fine-tuning is the Trump Administration’s goal.

In order for the Trump Administration to successfully micromanage the relative value of the US Dollar, it would need a clear set of goals – a target set of relative currency valuations –, a belief that the currency markets are best micromanaged by the U.S. government, and a belief that governments are capable of micromanaging currency values … as well as confidence in the ability of the U.S. government’s employees economists to correctly choose and perfect policies that will achieve the necessary country-by-country currency targets.

Analysts are bracing for direct U.S. government interventions in the currency markets. Goldman Sachs strategist Michael Cahill believes that “[d]irect FX intervention by the U.S. is a low but rising risk” and “anything is possible.” SocGen’s global strategist, Albert Edwards, believes it’s imminent: “In the intensifying currency war against the Eurozone (Germany), [Trump] will instruct the US Treasury (via the NY Fed) to intervene directly and unilaterally to drive the dollar lower. I am surprised he has not done so already….”

With the Fed prepared to lower interest rates and with tariffs biting, it’s unclear at this time whether the Trump Administration indeed will order the U.S. Treasury to take action.

Assuming that the lowering of America’s trade deficit through currency manipulation is a goal the Trump Administration will continue to pursue, what might happen if its efforts succeed and the US Dollar weakens? Can the weakening process be controlled and the targets successfully micromanaged? What might happen if the U.S. government’s currency targets overshoot … or if the targets themselves are flawed … or if, once confidence in the strength and safe-haven status of the US Dollar is shaken, the Dollar continues to weaken?

US Treasury bills, notes and bonds – America’s government-issued debt – are the world’s favorites. They also are the world’s most abundant – America’s Federal debt (excluding its State and private debt) now stands at $22 trillion. Because the interest rate on U.S. government debt is higher than the rate on every other developed country’s debt securities (other than those of Italy and Greece, both of which have virtually unsolvable significant economic problems), they’re the favorite of foreign institutional investors. It used to be that foreign investors prudently hedged their US Dollar risk, even though that reduced the yield advantage of the investments. They were willing to do so because of the stability and safe-haven status of the Dollar. With the recent strength of the US Dollar, many foreign institutions no longer see the need to hedge currency risk. After all, since the US Dollar has been increasing in value relative to the Euro, the Yen, the British Pound, the Chinese Yuan, etc., why not add to the interest rate advantage of U.S. government securities by capitalizing on currency translation gains as well?

Why not indeed?

What might happen to those investors and to their belief in the stability of U.S. government debt … and to their belief in the value of the US Dollar … if its value were to start sliding … and not stop? If the demand for U.S. government debt should decline, the interest rate on that debt would have to increase in order to attract investors. Increased interest on U.S. government debt would increase the amount of U.S. government debt that would need to be issued to pay that interest …, which would continue in a vicious circle. There’s a delicate economic balance among the interest rate set by the Fed, the demand for and stability of the US Dollar, the U.S. Federal debt burden, America’s trade deficit, tariffs, and a variety of other economic connectors that impact the American economy and the value of the US Dollar. The Trump Administration should be careful what it wishes for as well as the words it uses … and the steps it takes to make its wishes come true. A weakening US Dollar is not in America’s best interest.

The Trade War with China

The tariff war between the U.S. and China is not new to the Trump Administration. The Obama Administration started that war when it imposed anti-subsidy tariffs on Chinese exports of solar panels, wind towers, steel cylinders and aluminum extrusions, valued at $7.3 billion at the time. Who knew? Last week, in a case brought against the U.S. by China, an appellate decision by the World Trade Organization held that those U.S. tariffs had violated WTO rules. Unless the U.S. now removes those tariffs, it will face WTO sanctions.

In response, the office of the U.S. Trade Representative said: “The WTO appellate report undermines WTO rules, making them less effective to counteract Chinese SOE subsidies that are harming U.S. workers and businesses and distorting markets worldwide.” The Chinese commerce ministry had a different perspective. It said that the WTO appellate report proves that the U.S. “repeatedly abused trade remedy measures, which seriously damaged the fairness and impartiality of the international trade environment.”

The tariff wars have been going on for years. They’re not easy to win … and no one has been winning.

Finally (from a good friend)

*┬® Copyright 2019 by Wlliam Natbony. All rights reserved.