With the world’s central banks aggressively easing monetary policy overnight as analysts watch in stunned amazement as the world’s interest rate careens ever faster toward zero, Trump is angrily watching the dollar as it keeps rising day after day, bringing us ever closer to the moment the US president declares on twitter a “national emergency” over the dollar and unleashes a major dollar devaluation.
Which is why it is not at all surprising that today Bank of America has published a report warning that FX intervention risks are rising, in which the bank notes that it is inclined to think the first stage of any policy shift from the Administration will be to discard the strong USD policy and hope/persuade the Fed to ease rates further. It is also not surprising that BofA’s FX strategist Kamal Sherma believes the odds of intervention to weaken USD have risen in light of this week’s developments, but the success of any such actions would depend on a number of factors including the parameters around which intervention would occur.
Here Sharma reminds us of the textbook example of successful FX intervention, namely the Plaza Accord of 1985 when the G-5 nations coordinated to weaken USD.
So is another Plaza Accord imminent? As the FX strategist explains below, there are similarities between events then and now, but also crucial differences that lead him to conclude the US Administration will not be able to rely on its major trading partners to help weaken the USD.
The Plaza Accord revisited
As Bank of America writes, September 22 marks 34 years since the G5 leaders signed a collective agreement to weaken the USD against the backdrop of growing internal and external US imbalances (the dual deficit). The Plaza Accord is widely held as the most successful episode of coordinated FX intervention and in the following two years, the USD TWI fell nearly 50%. But, while the Plaza Accord is often viewed through the prism of coordinated FX intervention to weaken USD, the basis of the Accord was built on specific economic pledges:
the US promised to reduce its Federal Deficit;
Japan promised looser monetary policy
Germany agreed to a package of tax cuts.
Coordinated FX intervention was therefore part of an overall strategy to address the internal/external imbalances that drove USD appreciation. Though the Accord was ostensibly designed to help alleviate US imbalances versus other G-5 nations, Plaza is seen by economists as a direct response from the US of threat from Japan’s growing status as an economic superpower. It is consequently seen as the catalyst for Japan’s lost decade of growth through the 1990s.
In the run up to the 1985 Accord, the USD TWI appreciated 55% making it the largest percentage rally in the USD in the past 50 years taking place against the backdrop of tight monetary policy (under Fed Chair Volcker) and expansionary fiscal policy (Reaganomics). Martin Feldstein (former Chair of Council of Economic Advisors) has argued that USD strength was not the problem; it was symptomatic of the US policy mix. US financial conditions (according to the Chicago Fed, Chart 2) are comparable to current levels. To date, USD has appreciated by nearly 40% since its 2011 lows, and while there are similarities between the narrative in 1985 and now (increasing protectionist policies from the US Administration, concern over Japanese economic dominance), there are also differences between 1985 and the present period. In 1985, USD strength prompted extensive lobbying by US industry to weaken the greenback. While recent US earnings statements make it clear that there are rising FX headwinds to profits, systematic calls from US industry to weaken the USD have been largely contained (perhaps thanks to the offsetting benefit of record stock buybacks). In addition, while the driver of USD strength through the early 1980s was largely a function of the US domestic policy mix, the US Administration currently views dollar strength as a function of global central banks deliberately keeping policy loose in an effort to prevent respective currency appreciation.
Meanwhile, as Sharma notes, inflation targeting is increasingly becoming an ineffective tool and as central bank policy rates once again synchronize the result has been a policy of benign neglect toward FX. As the BofA strategist puts it, a weak currency suits the needs of many policy officials outside of the US and the recent downgrade by the ECB to its inflation projections suggests little motivation to challenge current exchange arrangements agreed in G7 communiqués. This is important because many countries (particularly France and Germany) were concerned about a weakening of their respective currencies versus USD in 1985. G5 countries were therefore a willing partner in efforts to weaken the USD. Now, FX is an essential part of the policy armory. Europe and Japan are now more accepting of FX weakness than FX strength.
According to some estimates, the combined interventions by G5 totaled $10bn. According to the BIS Triennial Survey, average daily FX turnover in 1989 was $655bn. Assuming a turnover figure of $500bn for 1985, total Plaza Accord intervention, accounted for around 2% of daily market turnover. With current daily turnover at $5.5tn, an equivalent amount of intervention would imply over $100bn in FX. According to BofA calculations, the US could muster reserves in excess of these levels (~$140bn), although it is clear that the amounts of intervention would have to be substantial and sustained for it to be credible. Meanwhile, in subsequent years, the Bank of Japan intervened on 126 days between January 2003 and March 2004, purchasing over $315bn to weaken JPY. This was a sustained period of intervention, but question marks remain over its long-term efficacy (note: such interventions were disastrous and only the current period of QQE helped stabilize the yen decidedly below 100 vs the USD). The effectiveness of interventions has more broadly involved the element of surprise and positioning: of note, BofA’s own proprietary indicators do not suggest investors are holding sizeable USD longs positions to make USD selling intervention have sustained impact.
How to measure success
As shown below in the bank’s Chart of the Day: “US Dual Deficit is Approaching Plaza Accord Levels”, the rapid depreciation of the USD following Plaza eventually led to a steady improvement in the dual deficit. However, the issue for the Trump Administration is whether that improvement can come ahead of the 2020 Presidential election for him to claim that his interventionist policy has been a success. His 2016 campaign pledge to narrow the US trade deficit (particularly with China) is currently at odds with the dynamics of external US trade data, which show the merchandise deficit with China hitting a five-year high in June.
Indeed, as noted above, the complicating factor for the US Administration is whether any depreciation of USD will lead to a material improvement in the trade deficit in time for the 2020 election. The J-curve theory suggests a country’s trade deficit will initially deteriorate following currency devaluation. Certainly the evidence from UK and Canadian trade data suggests both deficits have not materially improved since the financial crisis despite the 20% and 30% depreciations of CAD and GBP TWI respectively. What is clear is that with 15 months left until the 2020 Presidential election, any depreciation in USD is unlikely to have a material impact on the US trade balance. The US current account deficit continued to deteriorate until 1987, two years after the Plaza Accord.
What to expect in the coming months?
Ironically, the Osaka G20 Summit held earlier this year reiterated its commitments from March 2018 to refrain from FX intervention:
“Flexible exchange rates, where feasible, can serve as a shock absorber. We recognize that excessive volatility or disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will refrain from competitive devaluations, and will not target our exchange rates for competitive purposes”.
We say ironically, because the latest G20 Communiqué is effectively the antithesis of the 1985 Plaza Accord and along the with the US Administration’s strong USD policy are two initial challenges that it faces were it to intervene. Here, BofA would focus strongly on the Administrations’ commentary around both areas as signs that it is moving toward a more interventionist approach.
One way that this could be formalized is firming up the commitments around the US Treasury FX Manipulation Report, which is due for release in October, even though we already know that China will be declared a manipulator. At present, BofA sees bilateral negotiation as the only recourse the US has if it labels a country as a currency manipulator. There is one other possibility: the US could revise the framework around the FX Manipulation Report so it includes a new metric that takes into account the relative monetary policy stance of foreign central banks as a de facto signal that they have a policy of benign neglect toward their currency. Either the country in question reverses course on its monetary policy, or the US Authorities reserve the right to intervene to weaken the USD to create a “level playing field”.
And since not a single foreign central bank will concede to such a requirement in a time when the global race to the bottom, as the name suggest is “global”, the US will have free reign to finally unleash hell on the dollar.
Finally, we remind readers of an unorthodox – if highly efficient – method to devalue the dollar that was proposed by bond trading legend, and MOVE index creator, Harley Bassman back in 2016 when he worked for PIMCO – the Fed buying gold. Before all is said and done and the central banks’ reign of terror is finally over, we are certain that this dramatic step will also be attempted.