There once was a time when men thought
That trade wars should never be fought
But that was back then
And now those same men
Think trade wars can help votes be bought
However, attacking free trade
By building a tariff blockade
Can open the doors
To currency wars
Just like in Trump’s latest tirade
Jerome Powell’s job got a LOT tougher on Friday, when President Trump not only reiterated his concern over the Fed raising rates and the impact it would have on the economy, (i.e. tapping on the brakes), but on the impact Fed policy is having on the dollar as it continues to rise. The President then called out China, Europe and Japan for manipulating their currencies lower and calling it unfair and a serious problem.
Now put yourself in Powell’s seat. Maintaining Fed independence, and any perceptions thereof is crucial. But so is managing monetary policy as he see’s fit. However, now that Trump has complained about rising US interest rates and the ongoing policy divergence we have seen over the past fifteen months, if the US economy slows and the Fed believes that a change in policy is appropriate, it may look like he is bending to the President’s will. At the same time, if he continues to raise rates because he believes that is appropriate, he will seemingly come under further pressure from the President. As I said, his job got a lot harder. One doesn’t have to be too cynical to believe that Powell and the Fed will continue to raise rates until the economy falters, at which point it will be clearly appropriate for the Fed to ease policy, and there will be no question of the Fed’s independence. Of course, purposely engineering a slowdown or recession doesn’t seem like such a wonderful idea either.
At the same time, the President has just created his fall guy for any bad outcomes in the economy. If things go bad, he blames the Fed and says, ‘I told you this would happen if they raised rates.’ And if everything continues with positive growth, he claims it’s his policies in spite of the Fed that is doing the job.
With that as the lay of the land, it should be no surprise that on the back of Trump’s discussion of currency manipulation, that the dollar fell sharply in Friday’s session. The dollar Index fell 0.75% with almost every major currency rallying. As the Asian session opens this evening, we are seeing some follow through in that price action, with the dollar index down a further 0.2%. JPY is leading the way higher, up 0.45%, but the movement remains widespread.
Interestingly, it appears that most of the punditry have decided that the dollar’s rally is now over. With the President now keen to see the dollar fall, that is what will happen. I, however, disagree with that assessment. At this point, as long as the interest rate divergence continues, I see no reason to believe that traders are going to change their tune. The carry available remains too great a temptation to ignore. In fact, I wouldn’t be surprised if we see the current level of dollar bullishness, as measured by open futures positions, rise over the next several weeks, as traders take advantage of the dollar’s short-term decline to add to positions at better levels. Until we start to see concrete changes in monetary policy (and there is no indication that any other country is going to tighten policy sooner than they otherwise would have), the dollar still holds all the cards. In fact, if the ongoing trade ructions lead to a more significant equity market correction, meaning risk is jettisoned, then the dollar will probably rise further. I will change my views when policy changes, but for now, I see this move as a temporary correction.
There is really no other story in the FX markets right now other than the evolution of the trade war into a currency war. While there will be some data this week, and the ECB meets Thursday, everything we hear will be in a response to Trump’s comments. The G20 arrived at no decisions, which can be no surprise, as they never do. However, all the talk is on the trade cum currency war that is brewing. At this point, given the ECB is not going to change anything, (perhaps they will refine their rate message more specifically, but I doubt it), it is headline roulette until the Fed meets next month. And even then, there is no expectation of a move until September, so really we are beholden to the headlines for now. I wish I could give more guidance than that, but let’s face it; nobody knows what will happen there.