The White House is making the ‘cold currency war’ worse, and that could continue to wreck the dollar

steven mnuchin US Treasury Secretary Steven Mnuchin. Joshua Roberts/Reuters

  • The dollar has extended its declines this year after its worst annual performance since 2003.
  • Treasury Secretary Steven Mnuchin gave investors a reason to sell when he said a weaker dollar would benefit US trade.
  • Though Mnuchin and President Donald Trump have tried to undo the comments, they impaired the market’s confidence in a hands-off approach from the White House.
  • It doesn’t help that economies outside the US are strongly expanding, giving investors even more reason to sell the dollar.

The global foreign-exchange market is getting more tumultuous, and it’s to the dollar’s disadvantage.

The dollar has extended declines against other G-10 currencies this year after a 10.2% drop in 2017, its worst annual performance since 2003.

Traders were encouraged to sell last week when the White House led them to believe that it favored a weaker dollar and could weaponize the world’s reserve currency to help US trade. Treasury Secretary Steven Mnuchin said at the World Economic Forum that a weaker dollar was “obviously” good for US trade. Though both he and President Donald Trump later walked back those comments, the damage was already done.

Joachim Fels, the global economic adviser at Pimco, says there’s a full-blown “cold currency war” that the US is winning as the dollar remains weak.

“US President Donald Trump carries the bigger stick: the threat of protectionism,” Fels said. “And so Europe and Japan have acquiesced; neither has stemmed their currencies’ appreciation with words or actions.”

Markets can expect a weaker dollar to be part of US policy if the Trump administration continues to lament its growing deficit, and if the Federal Reserve doesn’t comment on the issue, said Shahab Jalinoos, a trading strategist at Credit Suisse.

“Even worse, if the ‘rule of law’ for FX markets is now being breached by a key player to the point that other ones complain in public, the odds rise of a more chaotic environment characterised by far less cooperation, even if we avoid outright ‘currency wars,'” Jalinoos added.

“This equates to higher uncertainty on a structural basis, which should set a floor under longer-dated FX implied volatility even if realised volatility falls and vol curves re-steepen.”

Screen Shot 2018 02 01 at 12.31.11 PM Mnuchin’s comments shook the global currency market. Credit Suisse

In other words, the White House is going to have a hard time convincing already unnerved traders that it will never try to influence the dollar.

In fact, Trump may have affirmed Mnuchin’s initial comments during his State of the Union address, deliberately or not, according to Christopher Wood, the author of the CLSA’s “Greed & Fear” newsletter.

Trump asked Congress for an infrastructure bill that generates at least $1.5 trillion. While this could be another catalyst for economic growth, there’s still uncertainty about how such a proposal, and tax cuts, would be financed by the US government, Wood said.

That concern “should help to drive continuing US dollar weakness which in turn should lead to accelerating inflows into the emerging market asset class,” Wood said.

A ‘perfect storm’

Recent action in US Treasurys shows why the outlook for the dollar is even more complicated.

In January, the 10-year yield jumped above 2.7%, its highest level since 2014. The most notable reasons traders have cited include expectations for faster US economic growth, more inflation, and higher US rates versus the rest of the world.

All these things should normally lift the dollar. Instead, there’s a continued split between the dollar’s performance and interest-rate differentials, with traders more focused on growth prospects outside the US.

Screen Shot 2018 02 01 at 1.24.00 PM Societe Generale

“The last significant divergence occurred in the 2002-2004 period,” Alvin Tan, an FX strategist at Societe Generale, said in a note on Wednesday.

Unlike that period, the global economy is strong, not fresh out of a recession. Add to that concerns that the dollar was overvalued when it peaked in late 2016, and you have what Tan calls a “perfect storm.”

“We expect global growth prospects to be favorable for the coming year, which implies that this perfect storm will continue to batter the dollar,” Tan said.

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