Be Prepared: Boy Scouts and US dollars

Boy Scouts and Girl Guides have the motto “be prepared.” It is intended to instil the habit of thinking ahead in children at an early age. 

The same goes for currency. As the US dollar is the world’s reserve currency, you know that if you go into any country with a fistful of dollars, you will, with only a few rare exceptions, be able to use them to buy goods and services. Yet, the same cannot be said for the Chinese yuan or the Russian rouble. Indeed, if anything happens in the world, then the dollar is sought as a safe haven, and a large percentage of commodities are priced in dollars. 

Central banks are happy to hold dollars as part of their reserves, and the dollar is backed by US Treasuries, which are deemed to be the safest of all paper assets. So, should we “be prepared” for any upcoming big news on the US dollar?

“Dollar is our currency, but your problem”

In the early 1970’s, US Treasury Secretary, Connally, told a group of European Finance Ministers, the “dollar is our currency, but your problem.” Since the 1990’s, the US has adopted a strong dollar policy, as it is assumed a strong exchange rate for the dollar is in the interests of both, the US and global economy. This indeed signifies a strong US economy, and a strong stock market. 

President Trump does not seem happy with this policy. He says countries like China and Japan, alongside the European Union, gain an unfair advantage with a strong dollar, as it allows them to sell more of their goods. Yet, it is worth noting that G20 nations have agreed to refrain from currency depreciation in search of a competitive advantage.

This was confirmed by ECB President, Draghi, in June, who said they do not target the exchange rate. However, Draghi then prepared the market for more monetary easing in the Eurozone. The ECB, of course, has set interest rates at zero, and bank deposits actually incur a negative interest rate of 0.4%. This additional easing would naturally lead the euro to be even less appealing to investors than it currently is, especially against the dollar which currently has a positive interest rate of 2.25%. So, President Trump tweeted commenting that Draghi’s move “immediately dropped the euro against the dollar, making it unfairly easier for them to compete against the USA.”

AFEX US Dollar Index 2017 to July 29th 2019

US Treasury Secretary Mnuchin has since commented that there has been “no change to the dollar policy.” Nonetheless, he added that “this is something we could consider in the future.” So, if the US does change its strong dollar policy, then what can we expect? They may try and get a weaker dollar policy agreed by G20, but this remains quite utopian, as it is unlikely that the other G20 members would give the largest trading nation in the world another leg up. In this case, it would probably have to be the US who takes unilateral action to try and weaken their currency.

Jawboning the dollar

The first step would be to try and “talk” the dollar lower. After all, the market is used to President Trump and his tweets. However, this approach would probably mean that US Treasury Secretary, Mnuchin, would have to also start encouraging a weaker dollar. If this is the case, the initial market reaction would probably be surprised, immediately followed by bouts of dollar weakness across the board. Yet, the law of diminishing returns suggests that this “jawboning” of the dollar would need to be continued in order to push the dollar lower on more than a short-term basis.

The next step would probably be for the Federal Reserve to sell dollars on the FX markets. This has been done before, but usually in conjunction with other central banks with the stated intention of smoothing excessive exchange rate fluctuations. This approach would also not go down well with the Fed, which is independent, although the US Treasury is responsible for managing exchange rates. It is worth remembering that if the US did intervene in the FX markets, then it would open itself to charges of currency manipulation from countries such as China. If the latter decided to respond in kind and weaken the yuan, this would increase the US trade deficit, which President Trump wants to cut. Governments would also not be pleased that their holding of US Treasuries were being devalued.

Even if the US managed to knock the dollar lower, in the short-term would they be able to keep it lower? Probably not, as the weaker the dollar, the more goods the US can sell overseas. This would feed through into better economic data for the US economy, enticing dollar buyers. And don’t forget that with the US interest rate at 2.25%, it is still above the UK, EU, Japan and the same as China’s cash rate, which encourages investors to buy dollars and gain a positive yield.

So, if the US decides to devalue the dollar, this will only produce a period of excessive volatility with accompanying weakness in the currency, probably only lasting for a short-time. If the newswires suddenly announce a change of this kind, then maybe it’s time to be a Boy Scout and think ahead by looking out for opportunities to hedge dollars at lower rates.

This has been prepared solely for informational purposes and does not in any way create any binding obligations on any party. The information provided here should not be construed as providing advice or recommendations of any kind. You should use your independent judgment and consult with your own independent advisors in evaluating whether to enter into a transaction. No representations, warranties or conditions of any kind, express or implied, are made in this document.