Is America about to wage a currency war? Politicians are jawboning about it. President Trump is tweeting at the Fed, complaining other central banks are devaluing currencies and suggesting the Fed follow suit. One 2020 Democratic presidential candidate—Senator Elizabeth Warren—advocates making currency war official policy under the auspices of a new Department of Economic Development. In our view, these are misguided ideas, but also not something investors need to lose sleep over today. Here is why.
A currency war, or competitive devaluation, is when a country employs policies targeting a weaker currency vis-à-vis trade partners. The idea: A weaker currency makes exports cheaper to consumers abroad, causing production to rise at home—boosting economic growth via external demand.
Seems logical. Trouble is, there isn’t much evidence it works. Consider Japan, which publishes both export values and volumes. In 2013, the Bank of Japan launched a massive monetary stimulus plan that drove the yen down -18% versus the dollar. [i] If currency war theory held, Japan should have seen a huge jump in exports. Yet even a cursory look at Exhibit 1 shows this wasn’t so simple. While export values jumped—the natural consequence of a weaker currency—volumes, or the quantity of exports, were weak. 2014 wasn’t much better, despite the yen falling another -12%. [ii] Volumes represent economic activity better than values, as they speak to the quantity of goods consumed—eliminating currency skew. With an export volume uptick absent, the weak yen likely had little juice for the Japanese economy. Instead, weak currency boosted firms’ revenues off currency translation tied to export values’ rise.
Exhibit 1: Weak Currency Doesn’t Automatically Boost Economic Activity
Source: FactSet, as of 7/10/2019. Year-over-year percentage change in Japanese monthly export volumes and values, January 2013 – December 2014.
Further, the notion a weak currency is an automatic economic boon is antiquated in our view, quasi-mercantilist economic logic. It overlooks the fact few firms produce goods with solely domestic inputs. They import many components, from natural resources to tech and electronics components, plastics and more. So while a weak currency may bring higher export revenues (again, in value terms), even those gains may be offset by increasing input costs.
But politicians often miss this—hence, the currency war chatter. So the question is: Could they declare currency war? And if so, how? President Trump’s tool seems to be the Fed. He argues other central banks are targeting exchange rates, and the Fed should “MATCH” them. You see, in currency markets, demand tends to follow higher interest rates. So in theory, if your country has rising rates relative to other nations, your currency will rise, too (and vice versa). This is likely a huge factor in the dollar’s strength before rate-cut chatter started. With other nations holding interest rates steady while the Fed hiked, demand for dollars rose. However, discerning normal monetary policy from a currency war could prove tough. The Fed’s 2018 hikes—and steady rates abroad—didn’t seem to be targeting currencies. They targeted central bankers’ perception of economic conditions.
As for Trump’s argument, the Fed doesn’t seem to be buying it. Fed Chairman Jerome Powell has clearly stated exchange rate policy is the Treasury’s responsibility. He further argues that, like central bankers elsewhere, he sticks to his legal mandate (aiming for stable inflation with maximum employment). Now, President Trump could try to change the Fed’s mandate, but such a significant change—unmatched in over 40 years—is highly unlikely to pass a gridlocked Congress. Particularly since it has lately been clear both parties support central bank independence. That makes Trump’s rhetoric look more like politicking before next year’s election than policy. So does the fact that he could mandate the Treasury Department to take action, like conducting foreign exchange transactions. But he hasn’t. Trump hasn’t even had Treasury label other countries currency manipulators—something he said he would do on day one.
The Treasury, though, is Senator Warren’s chosen weapon. She plans to direct the Treasury to sell US dollars (or dollar-denominated assets) to buy up foreign currencies, increasing the supply of dollars in the global market and boosting demand for foreign assets. All else equal, with increasing supply and steady demand, the dollar’s value would fall. That may sound plausible, but it isn’t a surefire plan. For one, the Treasury has long had an official “strong dollar” policy. Shifting that would be highly controversial. Also, crucially, the US government doesn’t hold all the sway here. Currencies trade in pairs. There is nothing preventing nations from retaliating, conducting offsetting transactions and rendering the whole operation moot. She says she would get other nations to cooperate, but if we are to believe they are manipulating exchange rates to their advantage now, why should we think they will go along?
For investors, currency wars are a long-running bogeyman—a false fear circulating throughout this bull market. They get lots of attention, but it isn’t clear they have any real effect. So, to us, the question for investors isn’t, “Could we get a currency war?” Rather, it should be: “Is US exchange rate policy causing unseen problems—regardless of the motivation?” Of course, a trading partner responding to what it saw as a currency war with tariffs or other retaliatory trade measures may be bad. But seeing that scenario as likely today is very speculative. Further, it isn’t worth considering unless and until it becomes a reality you can scale and analyze. So don’t fret it. The likelihood any of this comes to pass soon is low, and even if it does, it isn’t clear it would be bad. It may prove to be a feckless nothing, once again disproving currency war fears.
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[i] Source: FactSet, as of 7/10/2019. Percentage change in value of Japanese yen per US dollar, 12/28/2012 – 12/31/2013.
[ii] Ibid. Percentage change in value of Japanese yen per US dollar, 12/31/2013 – 12/30/2014.
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