“While direct [FX} intervention is no longer in vogue, central banks have increasingly become more proactive in their use of balance sheet tools, and it is not a giant leap from there to intervention”, Goldman wrote Thursday, in a note that found the bank joining the chorus of those warning that the Trump administration may soon resort to outright, active FX intervention to weaken the dollar.
As we’ve put it previously, competitive easing, trade wars and currency wars are inherently related and, in many respects, synonymous, so whether explicit or implicit, overt or tacit, this is a discussion we’ve all been having since Donald Trump became president. It’s just that now, as was the case last summer, Trump is stepping up his "currency manipulation” allegations, going so far as to call out Mario Draghi by name. It probably doesn’t help that Draghi chided the US for encroaching on central bank independence back in April.
Most banks (Goldman included) don’t see outright intervention by Steve Mnuchin as the most likely scenario, but with each passing day, we seem to get closer to some kind of tipping point.
Earlier this week, for instance, reports indicated Trump broached the FX subject with his latest Fed picks Judy Shelton and Chris Waller. And on Friday, the president was back on Twitter to complain about manipulation.
“Biggest part of deal with Mexico has not yet been revealed! China is similar, except they devalue currency and subsidize companies to lessen effect of 25% Tariffs”, Trump said.
Well, one person who thinks Trump will soon enter what the president has called “the big manipulation game” is SocGen’s Albert Edwards.
In a note dated Thursday, Edwards says the “US is set to take the global currency war to a whole new level”. A big portion of Albert’s latest is dedicated to explaining the dynamics at play across the pond, but if you skip to page 6, you find a reiteration of the point made here at the outset about extraordinary monetary policy and currency wars. Here’s Edwards:
I personally believe the ECB is effectively managing the euro lower. So Draghi’s pushback to Trump’s criticism is wholly disingenuous in my opinion. Indeed, I believe one of the only ways that QE actually works successfully is to indirectly drive down the currency. Of course, you are not directly targeting it, but you know as night follows day exactly what is going to happen. It is the same as the slump in the yen at the end of 2012 as PM Abe came to power in Japan and the BoJ stepped up money printing and the yen slumped. Monetary debauchery to drive down your currency to import inflation is exactly the prescription advised by Bernanke in his 2002 speech. The fact the ECB, the BoJ and the Fed haven’t been intervening directly in the FX markets doesn’t mean that this is not how QE works most effectively if it works at all.
Prior to that, Edwards runs through a detailed account of why the euro’s weakness “is particularly irritating to President Trump at the moment”.
“Where the eurozone stands out head and shoulders above other major global trading partners is in its gargantuan overall external surplus and this will not have gone unnoticed by the US president”, Albert contends, on the way to reminding you that “when we talk about the burgeoning eurozone external surplus, we all really know that is shorthand for Germany and so does Trump”.
The subsequent discussion spans several pages, but the gist of it is captured in the following short excerpts:
Germany’s overall current account surplus dominates the eurozone surplus and has been topping a massive 8% of its own GDP recently (although projected by the OECD to decline to 7.3% GDP this year). To be sure other European countries run bigger surpluses the Netherlands and Switzerland at 11% and 10% of their own GDP respectively. But these are small countries, and nobody really cares about them in terms of global macro imbalances. They do care about Germany though. With an external imbalance recently topping 8% of GDP, Germany now runs the biggest single dollar trade and current account surplus in the world. But Germany’s external macro imbalance has been unusually large since around 2004. What has changed? Why is it only in recent years that it has been attracting such aggressive attention and not just from the current Trump Administration, but within the EU itself?
Outside the EU, Germany’s gargantuan external surplus was more or less given a pass up until the eurozone crisis of 2011. That was because the eurozone periphery was the mirror image of Germany’s huge current account surplus (see chart below).
The problem for the rest of the world now is that under stringent post-eurozone crisis austerity, the eurozone periphery sponge has been totally squeezed out and the rest of the world is being now forced to soak up excess German saving.
Next, Albert runs through some analysis from former Goldmanite-turned IIF Chief Economist Robin Brooks. We’re going to use the entire block quote from Brooks here because it’s publicly available for free (you can read much more from the IIF here):
Output gap estimates from the IMF, OECD and European Commission (EC) have a common theme, which is that the degree of economic slack on the euro periphery is small. Indeed, the EC says that Spain and Portugal have positive output gaps this year (GDP above potential), even as its estimate for Germany is slightly negative (GDP below potential). These estimates are hard to square with economic reality, given that Germany has substantially outgrown both places over the last decade. The underlying issue is that these numbers don’t capture potential, ie activity levels consistent with stable inflation, and instead seem to be more about capturing realized outcomes over the last decade. That has the effect of “explaining away” stagnant growth outcomes and economic slack, which we now illustrate for Italy. In the period from 2001-7, real GDP growth averaged 0.9% per year. Assuming a permanent output loss of 5% in 2008 and trend growth of a third of its precrisis level, this puts potential GDP about 4% above actual, in contrast to IMF, EC and OECD estimates, which bend down to meet actual GDP, implying negative trend growth over the last decade. This seems an extreme assumption to us, which means that slack and thus deflationary forces are likely much larger than consensus allows. Our larger output gap numbers are consistent with Phillips curve evidence, helping to explain why core inflation has remained so low in the periphery.
With that in mind, consider the following summary tweet from Brooks and a reply from Paul Mortimer-Lee:
Campaign against Nonsense Output Gaps (CANOO): Germany used to export its surplus to Spain and Italy, i.e. the Euro zone. But large output gaps in Spain and Italy now mean Germany exports its surplus to the rest of the world. Euro zone output gaps are the world's problem! pic.twitter.com/DmxB7lko1T
— Robin Brooks (@RobinBrooksIIF) July 2, 2019
The misalignment of real exchange rates within the euro zone leads to inadequate demand outside Germany and some others, which gives de facto deflation. That gives ultra accommodative monetary policy, which gives a soft real EUR FX rate and external imbalances with rest of world. pic.twitter.com/N0eA5oLlcV
— Paul Mortimer-Lee (@MortimerleePaul) July 3, 2019
Edwards cites those tweets and then uses the chart below to illustrate Mortimer-Lee’s point. In the accompanying color, he writes that “under a single currency, if a country imports the wrong monetary policy and sees rapid wage/cost inflation it becomes relatively uncompetitive i.e., the REER rises as it did in the bubble years for the periphery”. Once the bubble bursts, the only way to recover that lost competitiveness (versus Germany in this case) “is to deflate costs in that economy relative to Germany”, Albert goes on to say.
Bringing it all together, Albert says that comparing the eurozone’s basic balance with the prevailing exchange rate leaves an unsquared circle, if you will.
“On the basis of fundamental flows of funds, it really is a bit of a mystery why the euro wasn’t much stronger last year – and especially this year but the mystery is solved by hot money flows driven by super easy ECB policy set beside Fed hikes”, he writes, on the way to sarcastically musing that “some” (and by that he means Trump) could assert that Draghi is “manipulating the currency lower”.
We would note that the IIF’s Brooks has tweeted multiple times about this over the past several days. Here are some examples for context:
Does the Euro zone current account surplus mean the Euro is undervalued? No! The surplus reflects demand compression & large output gaps on the periphery, where deficits have become surpluses (red). It's a symptom of internal imbalances, not external FX misalignment. #CANOO pic.twitter.com/mkuxpmvRK8
— Robin Brooks (@RobinBrooksIIF) July 10, 2019
Talk of currency wars is rising, reflecting the view that currencies are misaligned, that current account surpluses are ill-gotten & at expense of others. Not so with the Euro zone surplus, which is in part driven by large periphery output gaps, i.e. internal imbalances. #CANOO pic.twitter.com/tCGbuYmX33
— Robin Brooks (@RobinBrooksIIF) July 12, 2019
Coming full circle to the US, Edwards reiterates his long-held view that deflation will come calling eventually.
He cites the usual data in contending that underlying inflation is running much cooler than anyone cares to admit (e.g., US core CPI ex. owner equivalent rent but not actual rent and market-based core PCE), says the US is importing deflation again thanks to a resilient greenback and points to a plunging ISM new orders/inventories ratio as evidence of a “sharp and imminent GDP slowdown”.
Once it becomes clear that the domestic economy is decelerating markedly and the US is at risk of succumbing to outright deflation, Edwards sees Trump pulling out all the stops. Here’s Albert’s prediction:
I believe that the US will soon be forced by events to join the eurozone and Japan in aggressively fighting deflation. I expect that in addition to President Trump using auto tariffs as a weapon in the intensifying currency war against the eurozone (Germany), he will instruct the US Treasury (via the NY Fed) to intervene directly and unilaterally to drive the dollar lower – much lower. Actually, I am surprised he has not done so already, but any additional ECB easing will surely be the straw that will break the camel’s back. And unlike in the eurozone, it is absolutely clear and unambiguous in the US who has the call on FX intervention it is the Administration and not the Washington Federal Reserve. As well as the US directly intervening in FX markets, one policy tool I really believe will be weaponised is negative Fed Funds. With both the ECB and BoJ key policy rates already negative, it would be madness for the US Administration not to fight the global currency war on this battlefield in addition to all the others.
There’s much (much) more in the full note, which is easily the longest and most in-depth exposition from Edwards we’ve seen in quite a while.
After nine full pages and 18 charts, Albert wraps it all up as only he can. To wit:
Personally, I am surprised Trump has put up with the ECB winning the competitive devaluation game for so long. Expect the dollar to fall bigly.