Over the past two weeks, talk of direct, active FX intervention on the part of the Trump administration has reached a fever pitch.
At this point, it seems wholly implausible to suggest the US president is blissfully ignorant of the irony inherent in boasting about the relative strength of the US economy and complaining about the resiliency of the greenback. In the same vein, he surely realizes that the trade war is in no small part responsible for the global manufacturing slump gripping the rest of the world.
In short, Trump is aware of the extent to which he is demanding to have his cake and eat it too. He wants to perpetrate a trade war at the expense of the global economy, boost the domestic economy with fiscal stimulus, chide other nations for trying to shore up their economies with rate cuts and bully the Fed into cutting rates at home in order to offset the dollar strength engendered by US economic strength.
It also seems to have occurred to the president that Fed dovishness may not be enough to pull the rug from beneath the greenback. US yields have plunged in 2019 and rate cut bets have proliferated. But the dollar has remained resilient, in part due to the concurrent dovish pivot by the FOMC’s global counterparts and in part due to the fact that the US economy refuses to roll over (see the June jobs report and recent signs that inflation isn’t “dead” after all).
At wit’s end, and unwilling to concede on any front, Trump may ultimately be forced to resort to outright FX intervention, carried out by Steve Mnuchin and a begrudging Fed. For most banks, this isn’t the base case, but whereas last August it was seen as far-fetched, now, intervention is openly discussed as a very real possibility.
In a note dated Friday, Deutsche Bank’s Stuart Sparks and Steven Zeng touch on this topic in a roundabout away when discussing “external risks” and the “dollar constraint”.
After noting that Jerome Powell has now essentially committed to cut rates despite a healthy domestic economy, Sparks and Zeng note “the tension between evidence that weakness in domestic inflation might indeed have been transitory and the unambiguously negative external inflation environment”. In that context, they write, “the dollar remains a potential binding constraint on US policy [as] divergence between policy and the growth and inflation outlook in the US relative to other major economies risks dollar appreciation that would intensify downward pressure on US inflation”.
For the Fed, weakness abroad (i.e., external risks) is one of the main issues, which means the dollar becomes a crucial part of the decision calculus.
The visual in the left pane shows YoY relative growth between the US and G7 economies versus YoY changes in the trade-weighted dollar. In the right pane is a lagged dollar chart with non-petroleum import prices (inverted).
As the bank notes, “a strong dollar depresses import prices and puts downward pressure on traded goods inflation more broadly [so] the recent softening of the USD TWI portends tailwinds for goods inflation domestically, and a reversal of this recent trend threatens to exacerbate below-target inflation on the margin”.
Meanwhile, have a look at a chart depicting 10-year US yields versus the level implied by the new orders component of the global PMI:
In Deutsche’s view, “an accelerated easing cycle consisting of 50-75 bp of ‘precautionary’ cuts is consistent with stabilizing external growth and inflation”. Their house view is 25bp this month, in September, and then again in December.
However, in the event the external environment continues to weaken, the bank says the Fed will remain under pressure “to ease to short-circuit dollar strength that threatens a further dampening effect on domestic inflation” as outlined above.
Of course, you could easily argue that the number one risk to the external environment is Trump’s trade war, which brings us right back to the president’s “dollar insanity loop“.
The longer the trade war, the worse the drag on the global economy. The better the domestic economy, the wider the economic divergence between the US and the rest of the world, and the stronger the dollar. The stronger the dollar, the less effective the tariffs. The less effective the tariffs, the more incentive Trump sees to put on more tariffs. The more tariffs he puts on, the worse off the global economy becomes relative to the US economy. The wider the economic divergence, the stronger the dollar.
“And around she goes, where she stops nobody knows”… until it all dead ends in a global recession, that is.