Financial markets are focused on the ongoing trade war between the US and China—which goods and services are in play and what measures are being taken or threatened in each case. But the trade conflict could spill over into currency markets—and that’s a risk that bears watching.
Currency has been a friction point and an undercurrent throughout the trade wars. The US administration has ratcheted up its criticism of China for manipulating its foreign-exchange (FX) rate in order to keep it weak and export friendly. Actually, China has been maintaining a stronger yuan these days—not a weaker currency. But the US is clearly growing more sensitive to currency moves.
That makes Monday’s decisive weakening in the yuan, a day that saw it move above seven per US dollar, a clear shot across the US bow. If currency tensions mount, the Trump administration could break with US practice and intervene to try to weaken the dollar. We think this action would disrupt financial markets and risk assets, broadening the trade war to other countries that would be hurt by a weaker dollar.
Currency markets are a zero-sum game: if the dollar is going to weaken, other currencies must strengthen. Much of the rest of the world is already on its back foot economically, so stronger currencies might be enough to push Europe and Japan into recession, and policymakers there would have to respond. Again, this possibility is still an “if,” but it’s a risk that needs to be monitored.
Currency Intervention Has Been Rare, but It’s on the Table
The ebb and flow of FX markets determines the value of the world’s currencies, but from time to time, policymakers step in to buy or sell their home currencies in an effort to influence their value—in essence, trying to overrule the market. Intervention used to be common, but it’s been very rare in developed markets since the mid-1990s. The US hasn’t targeted the dollar’s exchange value with intervention.
Currency intervention is rare because it’s not usually very effective. Currency markets are massive, and it isn’t clear that intervention can sustainably change a currency’s value. In addition, better global coordination among policymakers has led to widespread recognition that FX intervention is a beggar-thy-neighbor policy. If one currency gets stronger the others must get weaker, which may spur retaliation. If everyone intervenes, nobody gets anywhere—meanwhile, financial markets suffer.
Still, in our view, currency intervention by the US is now very much on the table. Presidential advisors have publicly indicated that it’s been a discussion point in the White House. That alone is extremely unusual—and it’s clear that the administration is very sensitive about FX rates.
The Mechanics: How Currency Intervention Works
How would currency intervention work? The president can order an intervention without any checks or balances. The US Department of the Treasury would order the Federal Reserve to sell dollars into the market, using its trading desk at the Federal Reserve Bank of New York. Historically, the Fed has also participated in interventions by using its own funds in equal amounts, in order to emphasize that the policy is coordinated. The Fed isn’t legally required to do this, but we expect that it would, rather than risk openly disagreeing with the executive branch—the legal arbiter of currency policy.
If an intervention does happen, we expect the US Department of the Treasury and the Fed will try to be as transparent and public as possible. Academic literature and evidence from past interventions make it clear that the moves need to be signaled to make them optimally efficient. In this case, the Federal Reserve Bank of New York’s trading desk would sell dollars to major dealers, and the US Department of the Treasury would simultaneously announce an intervention in FX markets.
The Policy Signal Is as Important as the Policy Action
If the Trump administration does intervene, it will need a loud and clear signal. That’s because the dollar amounts involved make it pretty obvious that intervention by itself won’t have a lasting impact on moving the dollar. The US Department of the Treasury holds about $95 billion in assets in the Exchange Stabilization Fund, most of which could readily be turned into liquid dollars to use in an intervention. If the Fed matched that amount, that would be $150 billion to $200 billion ready to sell. That sounds like a lot, but the FX market sees several trillion dollars of turnover each day.
We believe that an intervention would likely be initially effective at weakening the dollar, but the staying power would depend a lot on a combination of other policymakers’ responses and the US administration’s willingness to keep intervening if needed. There’s no theoretical limit on how much of a country’s own currency it can sell—once existing reserves are gone, the US Department of the Treasury could issue more debt, using the proceeds to sell more dollars.
The Implications of Currency Intervention
What are the odds of FX intervention? To be honest, we don’t know. This decision is at the president’s discretion, and as the past couple of years have demonstrated, his policy preferences can be unpredictable. If intervention becomes more likely, we expect that the administration will threaten to intervene before actually doing it. The hope would be to prod other countries into action without resorting to intervention itself.
But as we see it, the cat’s out of the bag.
Currency intervention is now a policy tool that can be wielded at any time, and investors will have to monitor it closely. We don’t think risk markets will react favorably if the US intervenes in the dollar’s value. A weaker dollar might be good for US corporate exports in the long run, but the near-term risk of stoking more global confrontation and tension—as well as weakening the global economy—would likely cancel out that benefit.
- Eric Winograd
- Senior Economist—Fixed Income