Trade war takes dangerous turn toward currency wars

Chinese fiscal and monetary authorities permitted the yuan early this week to slip below the important psychological level of 7 to the dollar for the first time since 2008. It was a retaliatory measure by China against President Trump’s threat to impose an additional 10% tariff on $300 billion in Chinese exports, beginning Sept. 1. The Chinese government also ordered a halt to all purchases of U.S. crops.

These moves represent a significant escalation in the trade war. As the stress in financial markets indicates (a wide array of financial assets declined on Monday morning, including the S&P 500 Index, which dropped 3%), the United States may now have to turn to a dollar devaluation to prevent further spread into the real economy.

These types of beggar-thy-neighbor policies were a hallmark of the Great Depression and caused a much larger economic downturn in their aftermath. The move from retaliatory tariffs to currency depreciation now threatens to become a part of the U.S.-China trade war and will impact trading partners.

There is a specific logic and order of operations with respect to the tit-for tat retaliation likely to play out that will not result in longer-term inflation, but will instead create conditions for deflation and negative nominal interest rates along the U.S. maturity spectrum if a longer-term trade compromise cannot be reached.

There has been much recent speculation about whether the United States would intervene in global currency markets to weaken the greenback in pursuit of Washington’s attempt to rebalance its trading relationship with China and others. If U.S. intervention were to occur, it would represent a significant policy shift away from free markets and free trade, which characterized the 1981-2016 period.

Intervention in currency markets fell out of favor during the last 40 years, largely due to failure. Governments chose instead to let their national currencies float, providing an important mechanism of adjustment to rapidly changing domestic and external economic conditions. However, the rise of economic populism and the brand of mercantilism favored by today’s White House has elevated the possibility of intervention in currency markets, even raising the possibility of capital controls utilized as leverage in the ongoing trade conflict.

Legal authority

The legal authority for the president to conduct significant interventions in global currency markets resides with the Gold Reserve Act of 1934, which created the Exchange Stabilization Fund, a U.S. Department of Treasury emergency reserve fund. There is little doubt that President Trump has the authority to devalue the dollar, subject to the willingness of Congress to consent, and the Federal Reserve to cooperate with Treasury if the President directs it.

Firepower

The ESF, which started with about $2 billion, now holds approximately $96 billion in funds. Those funds are based on $22 billion in dollar assets, $13 billion in euro and yen assets, and $51 billion in special drawing rights. While that may seem like quite a bit of capital, the global currency market is a deep and liquid $5 trillion-per-day market. Thus, the ESF holds a relatively limited amount of firepower. The use of financial weapons to manage trade policy objectives will require a unique form of government cooperation and a willingness to support, sustain and potentially overshoot whatever quantitative objective for the dollar is initially set forth by the fiscal authority.

MIDDLE MARKET INSIGHT: While large multinational companies, such as Apple (AAPL), likely have enough margin to absorb the bulk of the additional 10% tariffs, small and middle market businesses likely do not. As a result, the pass-through cost of tariff increases to consumers will accelerate. 

Simplified example: Who pays for what and how is the price set?

If a company imports $100 of goods from China, and the U.S. fiscal authority slaps a $10 dollar tax on those goods when they arrive at the Port of Long Beach, the importer pays $110. If the Chinese fiscal and monetary authority engineer a 10% depreciation in the yuan, then the importer pays the equivalent of $90 for the goods and then the 10% tax at the port of entry, which brings the importer’s total to $99 dollars. Contrary to what occurs in a trade war, which is mostly inflationary, when financial weapons are introduced into the policy environment the prospect of deflation increases, carrying with it a certain logic for central banks committed to price stability and maximum sustainable employment. In other words, the balance of risks shift toward attempting to protect pricing from the effective lower boundary of zero interest rates and lower inflation expectations. As a result, interest rates will fall toward zero if the trade and financial conflict does not end. Those conditions are commensurate with deflation and negative nominal rates. From our point of view, that is the major risk over the medium to long term if the trade and financial conflicts do not end soon.

A key indicator of stress in the real economy is the Bloomberg Financial Conditions Index, which declined precipitously beginning late last week. A Z-score of 0 is neutral, while a Z-score below 0 indicates tight financial conditions. This index implies companies should be on guard against tighter financial conditions in the real economy.

The Federal Reserve

Given the changes in the structure of central bank independence since 1934, it is not assured that the Federal Reserve will go along with devaluation of the dollar. This would require an aggressive reduction in the federal funds rate, or yield targeting. From a technical perspective, this would require the New York Federal Reserve to monetize special drawing rights, which would then be matched by the Federal Reserve, effectively doubling its firepower. While that is small in contrast with the daily volumes of foreign exchange, anything larger would require the consent of Congress, which is not assured, given the political polarization in the legislative branch.

One thing that we are certain of is that the forward-looking fixed-income market will not wait for intra-government cooperation. Bonds will continue to reduce long-term rates linked to a deteriorating global economic outlook, potential widespread damage linked to a currency and trade war, and the broader deceleration in the economy. Deceleration will likely hasten, given the escalation of the trade and financial conflict. It is hard to see how the Fed stays out of the game, given the pressure put on it by financial markets in the wake of the beggar-thy-neighbor policies certain to be put into place by other fiscal and monetary authorities in response to China’s initial devaluation and any depreciation engineered by the White House.

Technical difficulties

The major question in such a scenario: Would a depreciation of the dollar actually work? Well, that would depend on how it is executed. Foreign exchange intervention is defined as any attempt by the fiscal and monetary authority to influence the value of a specific foreign currency or basket of currencies. These type of interventions are conducted in two ways—unsterilized and sterilized. 

Unsterilized interventions happen when the fiscal and monetary authority attempt to influence currency values by purchasing (or selling depending on whether the desired currency outcome is to decrease or increase the currency) foreign assets without any other offsetting transaction. Thus, as the central bank increases (or decreases) the monetary base, the short-term interest rate declines (increases) and the value of the domestic currency falls (increases). Without a doubt, unsterilized currency interventions attempt to directly depreciate (appreciate) the value of the domestic currency. A sterilized intervention, by contrast, attempts to ring-fence domestic monetary conditions from an intervention in currency markets by engaging in offsetting transactions in domestic assets. If the administration decides to depreciate the dollar, we doubt it will attempt to do so through a sterilized intervention.

Any attempt to intervene in the global currency market to force yuan appreciation will have to navigate the wedge the Chinese have constructed in their currency market. That is, there are two fundamental currencies: the onshore yuan, which is used within China's domestic economy, and the offshore yuan, which trades on foreign currency markets and is used to purchase goods not available in China. Without a doubt, Washington can attempt to intervene in currency exchange markets to engineer an appreciation of the offshore yuan, which through midday trading on Monday was about 7.092 to the dollar. However, the United States does not have the power to intervene into China's domestic yuan market, which suggests that any domestic Chinese fallout in the near term due to the outbreak of financial hostilities will be limited.