ref: - "A currency war Trump was never going to win”, Opinion by Megan Greene of Harvard Kennedy School, The Financial Times 16/8/19
A bit of a breather this morning… just a touch of "risk-off" mode in evidence with stocks and bond yields managing a bit of a rally. Mind you, if you'd only been reading the weekend press you might have been forgiven for approaching the new week in a darker frame of mind. Naturally, much of it revolved around last week's inversion of the most closely watched part of the yield curve, when the yield on 2yr US Treasuries briefly went above that of the 10yr equivalents. As we are always hearing (please… make it stop!), yield curve inversions in general and of the 2yr/10yr in particular are seen as pretty reliable indicators of forthcoming recession.
With pessimism reinforced by the 30yr Treasury yield going below 2.00% for the first time ever (again… briefly), the prophets of doom have been out in force in the media. Well, fair enough… these are worrying times indeed and that pessimism may well turn out to have been justified. It's worth repeating just a few caveats, however:
The 2yr/10yr guide, whilst fairly reliable as these things go, is not fool proof -- 7 out of 9 recessions in the US have been preceded by yield curve inversion since WW2. And whilst most recessions have been preceded by inversion, it does not follow that the same percentage of inversions are followed by recession… it's a lower figure.
There is invariably a considerable time-lag between inversion and the onset of recession… usually at least a year. The yield curve will have to stay inverted for the signal to be strong.
Whilst the threat of importing global economic headwinds is very real, we shouldn't forget that right now most US data is pretty robust.
A world of ultra-low or even negative rates, with bond yields in particular squashed by massive post-crisis central bank bond-purchasing programmes (QE), means that old interpretations of yield curves and the like may no longer apply… or at least, not as rigidly.
The other thing grabbing people's attention is the annual gathering of central bankers and economic bigwigs at Jackson Hole, Wyoming -- a venue originally chosen incidentally to indulge then-Fed Chairman Paul Volcker's love of fly-fishing. Ah, those were the days! It starts on Thursday and current Fed boss Jay Powell speaks on Friday. His subject will be "the challenges faced by monetary policy". Wow, where would one start? De-globalisation and Pres. Trump's trade wars? The lack of ammunition implicit in a super-low / negative rate world? He's bound to mention that the dangers are largely international rather than domestic. We'd also love him to include in the list the challenge to monetary policy presented by presidential abuse and twitter assaults, though sadly he's likely to keep shtum about that one.
Anyway, market players will be desperate to glean whatever pointers they can as to the Fed's current thinking on rates. Right now, hot favourite amongst scenarios is that there will be a 25-basis point cut next month, though some commentators are still calling for a more decisive 50bp move. Futures prices show that traders are mostly split between rates being 50bp and 75bp lower at year-end. Given that Mr Powell has been criticised for less-than-perfect forward guidance and communication skills, his performance will be fascinating as well as… hopefully… informative.
This article in the FT is one that we were going to bring to your attention on Friday before some implosion or other scuppered things but it's worth a look if you can dig it out. The background to it of course is President Trump calling out China as currency manipulators, massaging the Yuan lower in order to gain a commercial advantage, and the implied threat that US might intervene in foreign exchange markets to weaken the US Dollar in response.
The Swiss and even on occasion in the past the Japanese have acted to weaken their currency, or at least to keep a lid on it, often to counter unwelcome appreciation due to safe-haven buying. But coordinated action by central banks is something not seen for quite a while. Back in 1985 at a deal known as the Plaza Accord, the US, West Germany, France, Japan and the UK agreed to sell dollars against the D.Mark and Yen in order to weaken the rampant US currency. They were so successful that less than 2 years later in 1987 they had to strike the Louvre Accord to reverse the move. You could also call that deal a success, though it took some time and also required US rate hikes that were in part responsible for a recession.
Back to the present, and there is no chance of putting together such harmonised central bank action. For one thing, President Trump and Treasury Sec. Steven Mnuchin have not stopped at labelling China a currency manipulator (even though China does not meet the Treasury's own criteria for such a tag). They have also put Japan, Germany and Italy on a manipulation "watchlist". This is despite the fact that because of its status as a safe-haven the Yen has been appreciating, not weakening. And of course, Germany and Italy do not have their own currencies to manipulate. No, if the US wants to intervene then they'll have to do so on their own.
Ms Greene's point is that even the US lacks the firepower to win a currency war singlehanded. Ms Greene reckons that the US Treasury's exchange stabilisation fund (ESF) has about $95bn to throw at the problem. In the past the Treasury's contribution was always matched by the Fed, though in current circumstances that wouldn't be absolutely guaranteed -- can you imagine the row if the Fed declined to participate in the president's crusade? Nevertheless, let's assume a total of $190 bn at the US' disposal. There would no doubt be some knee-jerk reaction to the US embarking on such a course, but on any longer-term basis a pot of $190 bn in a market where $5 trn is traded daily does not amount to a hill of beans. Not only would it be unsuccessful, but the global tensions that such a move would provoke would create economic and market turmoil for all, including the US. To quote Ms Greene:
"Showing up alone on the battlefield with the equivalent of a pea shooter is bad enough. Creating a circular firing squad in the process is even worse."
Of course, with this administration that doesn't necessarily rule it out…