Presenting, The Dollar Intervention Delusion

If there’s anything market participants should have learned this year, it’s that underestimating Donald Trump’s willingness to pursue self-defeating policies is a fool’s errand.

Of course “self-defeating” policies are by definition fool’s errands themselves, so another way to state this is to say it’s a fool’s errand to underestimate the President’s penchant for embarking on fool’s errands. Or, if you want to reduce this to its common denominator, one could just say you’re a fool if you think Donald Trump isn’t a fool.

There are myriad examples of the President adopting policies that trip over one another. The administration’s hardline stance on Iran and Trump’s desire for lower prices at the pump is a case in point. Higher gas prices have the potential to eat away at the savings that accrue to U.S. consumers from the tax cuts, so Trump needs lower crude prices, but reimposing sanctions on Iran’s energy sector is conducive to driving oil prices higher. So what you end up with is Trump screaming at Saudi Arabia in all-caps on Twitter – literally.

But the quintessential example of Trump driving himself crazy is what we’ve variously dubbed the “dollar insanity loop” wherein the combination of late-cycle fiscal stimulus and tariffs point to higher inflation outcomes (at least in the short term) and thereby beget a more hawkish Fed. Of course a hawkish Fed is USD+, and the stronger the dollar, the less effective the tariffs. Trump’s “solution”, thus far, has been more protectionist cowbell. To the extent protectionism is inflationary in the early stages, he’s running up the down escalator. The next round of tariffs on China (targeting an additional $200 billion in Chinese imports) is likely to hit consumer goods, thereby raising the chances of an inflation overshoot.

At wit’s end, Trump last month took to openly calling for lower rates, going so far as to declare, on Twitter no less, that the Fed is “now hurt[ing] all that we have done.” The paradox is that to the extent “all that we’ve done” means supercharging the economy with fiscal stimulus, Trump should look in the mirror when it comes to figuring out who to blame for hawkish Fed policy.

But self-reflection (figurative or literal) isn’t this President’s thing, so the next logical (or illogical) step here is for the President to actually intervene in the currency market to drive the dollar lower. We wrote about this on Wednesday evening, but it’s worth highlighting a few additional passages from the JPMorgan note cited in that linked post in the interest of fleshing this discussion out a bit.

The note that’s getting the attention this week is by Michael Feroli, who on Monday suggested that while not the bank’s base case, it’s not wise to completely rule out a currency intervention by the Trump administration, especially in light of the President’s comments late last month which focused the trade war squarely on the FX market.

In his piece, Feroli details the mechanics of a potential intervention, which just means the Treasury deploying the ESF – this:

As Feroli notes, the Fed would be expected to effectively double the ESF’s firepower if Treasury decided to deploy it. Here’s JPMorgan:

The Fed has two roles in US currency policy First, Treasury interventions are executed by the Federal Reserve Bank of New York. This includes monetizing the SDR assets and conducting the currency purchases or sales. Second, the Fed has traditionally matched Treasury intervention funds on a dollar-per-dollar basis.

Is that matching mandatory? In a word: no. As Feroli goes on to write, “it wasn’t until 1961 that the Fed’s lawyers judged that they had the appropriate legal authority to join Treasury in intervening [and] members of the FOMC have occasionally chafed at partnering with Treasury in currency interventions.”

The only reason this debate hasn’t come up very often is because the U.S. typically doesn’t intervene in currency markets. Would Powell’s Fed go along with the Treasury in a hypothetical intervention? Probably, because if not, they would open the door to criticism from Trump or, as JPMorgan puts it, “failure to cooperate with Treasury could bring unwanted political attention at a delicate time for the Fed.”

Feroli does note that this wouldn’t compromise monetary policy as the intervention would be sterilized, but I can tell you what wouldn’t be “sterilized”: the optics. By falling in line with Treasury (as opposed to say, insisting that the Fed shouldn’t be fighting trade wars for Trump) Jerome Powell would invariably be criticized for not pushing back. Something tells me Trump’s critics on Capitol Hill wouldn’t be all that interested in hearing about the mechanics of sterilization.

Of course even if Trump pulled the trigger on this, it wouldn’t work. “It would require a mind boggling amount of dollar sales to have a material influence”, Bloomberg’s Ye Xie wrote on Thursday, adding that “the daily turnover in dollar transactions amounted to $4.4 trillion in 2016, more than 20% of the U.S. annual GDP.”

Let’s say Trump can be convinced that generally speaking, a broad-based intervention simply wouldn’t work. Would a more targeted approach aimed at the bilateral rate with China be feasible? Probably not, for a whole host of reasons, some of which are discussed by JPMorgan’s Feroli.

The most obvious issue is that while China has recently countenanced yuan depreciation in an effort to offset the effects of the tariffs (both implemented and proposed), and while the PBoC did of course devalue in August, 2015, China has gone to great lengths over the past three years to avoid excessive depreciation – if only to guard against capital flight. They’ve sold reserves, added an absurdly opaque counter-cyclical adjustment factor to the fixing mechanism which can be deployed at the drop of a hat in the event the yuan weakens too quickly, and on and on. But from a technical standpoint, the problem is as follows, as detailed by Feroli:

Another potential problem is that China maintains capital controls such that any potential intervention by the US would need to be undertaken in the offshore CNH market. While pressures in the CNH market have often been transmitted into the onshore CNY market (via institutions, including corporates, who have access to both markets and can arbitrage any difference in prices), the PBOC, through regulatory and other means, can sustain a wedge between the two markets if it so desires. Of course, such actions come at a cost, including raising questions about China’s declared aim to internationalize the use of its currency and continued inclusion in the IMF’s SDR basket, but there is nothing intrinsic in the structures of the offshore and onshore yuan markets that guarantee price equalization. Consequently, interventions in the CNH market can have little or no impact on CNY depending on the countermeasures the Chinese monetary authorities undertake.

In other words, the PBoC could simply decide that at least in the near-term, RMB internationalization is going to have to take a backseat to defending CNY against undue appreciation pressure, in which case Trump would just be beating his head against that wall in the offshore market trying to force the onshore yuan to do something Beijing isn’t going to let it do.

Coming full circle, the real punchline here when it comes to the Trump administration’s penchant for self-defeating dynamics is that, as the above-mentioned Ye Xie writes in the same cited note, “in the unlikely event the U.S. succeeds in driving down the dollar, it may force the Fed to accelerate rate increases to mitigate the inflationary pressure.”

Around we go in the insanity loop, where it stops, nobody knows.