This spring’s sharp rise in the mighty dollar has caused major trouble for the world’s markets, says Michael Wilson. But has Donald Trump scored an own goal? And if so, does he know it yet?
Right, here’s a question for you. When was the last time you heard a great nation’s leader extolling the manifold virtues of having a strong national currency as a symbol of a great national economy?
OK, a clue. I’ll start you off with Margaret Thatcher, who thought that a strong pound was a symbol of a strong and dominant Britain. And I’ll also give you a few EU economists who took a brief pride in the vigorous way that the euro overtook the dollar during the early noughties – mainly, they felt, because it demonstrated a growing dominance of euro-denominated bonds vis-a-vis the US dollar, and thus seemed to confirm that they were onto something good. But for most of the last thirty years, the objective of strong trading economies everywhere has been to keep the value of their currencies as low as reasonably possible.
There are three reasons for that:
- It helps to make your exports more affordable, so that other countries will buy more of your goods.
- It encourages your own citizens to buy home-manufactured goods rather than imports.
- It makes it cheaper for foreigners to invest in your country’s businesses, so that with a bit of luck the trickle-down effect will benefit all your people.
“This time it’s different….”
All things considered, then, you’d expect that President Donald Trump’s Republican Administration would be in favour of a weaker dollar, because it has the power to transform a current account deficit into something closer to a surplus. (Or a surplus into a bigger surplus.) Japan has been manipulating its currency downwards for three decades, after all; China has done likewise, according to Mr Trump.
And Germany, if you believe the Trump rhetoric, has been wangling an unwarrantably cheap currency ride ever since the late 1990s, when the President insists that the conversion rate from the old Mark into the current Euro was negotiated at a criminally undervalued exchange rate, so that Germany’s cost of production has been outrageously understated ever since. All of which, he says, is why Europe’s trade policy stinks.
Discuss, as they say. But, in a peculiar way, maybe it explains Mr Trump’s current position, which is that a strong dollar is good for America’s trading economy, and not a cause of problems. Excuse me while I laugh, because it was only as recently as 24th January that his Treasury Secretary Steven Mnuchin was still telling the Davos meeting that America did indeed want to see the dollar going lower. Only to find his boss humiliatingly contradicting him the very next day: Mnuchin was still learning the ropes, the President said, and he wanted to see the dollar getting “stronger and stronger”. A currency “should be based on the strength of the country,” he added. Thus winding back the fiscal wisdom by some forty years.
That’s an important change of policy direction, as you’ll probably agree. Whether or not it will last for six years or six months or six weeks is something that nobody can properly tell in the volatile age of Trump – but, on the face of it, a muscular greenback seems likely to do as much collateral damage to the United States as it does to America’s international competitors. What it will also do, meanwhile, is pitch the world’s assumptions about fiscal integrity and sound fiscal policy into unknown territory. No wonder so many fund managers are getting perplexed.
Partly, it’s our own fault. We’ve had many decades in which to get used to the accepted balances between currencies, inflation and budget overshoots, and the grass has probably grown over our complacency, and so we find ourselves short of answers when somebody changes the rules. By throwing a punitive trade policy actively into the mix, President Trump has shifted the parameters in ways that have yet to be seen. This year’s heavy weather for some emerging markets (not all, of course) is being seen as an expression of that uncertainty.
There are several reasons for this, of course, and we’ll look at some of them shortly. But there’s ’s another thing that’s changed over the years, apart from the resurgence of competitive China and the apparent abandonment of budgetary restraint in the United States. America is now a shale-oil superpower, with very nearly enough hydrocarbon production capacity to be self-sufficient. (And, you may recall, the ability to promise Britain that if Vladimir Putin ever tried to turn off the Siberian gas taps it would be able to supply liquefied petroleum gas in lieu.)
The thing is, all of this matters – if only because it adds to the gravitational pull of the world’s traditional currency of last resort. And, the Prez hopes, and because it gives Washington yet another lever with which to influence the course of international decision-making. In the aftermath of Trump’s early-May withdrawal from the Iran nuclear deal, that attractional power to influence policy suddenly seems a little more troubling than it did previously.
Good news, bad news
You might of course argue, with good reason, that America would have been very likely to get a stronger dollar this year regardless of whatever the President happened to want. By the end of last year, it was already becoming apparent that US economic growth was driving up wages and unemployment down (3.9%) to the point where the Federal Reserve would need to raise interest rates pretty soon, just to stop an incipiently inflationary economy from running away out of control.
Sure enough, it was the announcement of some truly excellent employment statistics in January that pitched the US equity scene into a 10% correction that same month. The logic of the correction, you might recall, was that the impending rise in US interest rates would make it harder for US companies to invest and expand; it would also deter consumers from buying new products, and when they did buy those goods they’d suddenly find that foreign products were cheaper than US products.
More to the point, however, a rise in US bank rates would immediately feed into higher bond yields, which need to compete with cash; and that in turn would impact on corporate dividends, which also need to compete with the other two; and that the only likely result would be a fall in both bond prices and US share prices.
Both of which we have seen in ample abundance. The benchmark US Treasury bond was nudging 3% by the time we meant to press – up from 2.4% at the start of 2018, or 1.8% when Trump was elected back in November 2016. And the S&P 500 was down 7.2% from its January peak. A pattern which has been echoed meanwhile in most other western markets.
The international dimension
The 3% bond yield development is not all bad news, even considering that US inflation is at 2.4%. So what if there are clouds gathering over the sustainability of US economic growth, some say? Washington’s 2.8% projected growth for this year is still one of the highest in the developed world. (You’d need to turn to China, India, the Philippines, Indonesia or some parts of Turkey and Eastern Europe to beat 4%, and some of those come with much higher political risks.) And even if Washington’s leadership appears chaotic, it still has its attractions for a serious investor with serious responsibilities to meet. (And a mandate to hold a sizeable proportion of a portfolio in fixed interest.)
I am indebted to the anonymous commentator in the Financial Times who observed that high US bond rates are not without their advantages even if they do mean that bond investors have taken a bath recently. If you had the choice between a 10 year Treasury bond paying 3% and an equivalent Italian bond paying 1.8%, he asked, which would you be inclined to go for?
There are alternatives, of course. You could get a 10% yield from Brazil, or 7.5% from Mexico or India or Russia, but that would be strictly at your own political risk. And at the other end of the spectrum, a negative real yield from strong-and-stable Germany or Japan or even France wouldn’t exactly make you feel rich either.
Could you shore up your failing returns by turning to high yield and junk bonds instead? Indeed you could, but it’s been apparent for some time that the flows into high yield have been slowing and turning toward reverse. And that, of course, may be precisely because Trump’s trade posturing has cast a real uncertainty over the fortunes of Latin America in particular.
Still King of the Hill
On balance, then, it would be foolish to dispute that being the world’s traditional reserve currency has its advantages for the dollar. Universally stable, and endlessly liquid and fungible, and with an economy that is spewing shale oil, it stands in stark contrast to (say) near-bust Argentina, which was obliged in May to raise its central bank rate abruptly from 30.25% to 40%, just in order to hold its currency on the straight and narrow. And to stop an egregious outflow of hot money. (Informed opinion says that the 40% rate is unsustainable at a time of “only” 25% inflation, not least because it will kill investment and bust leading companies.)
Which brings us onward, or rather back, to our second, more contentious assertion. Which is that President Trump’s bullish, ebullient and often bird-brained misunderstanding of fiscal and trade economics shouldn’t hold us back from comparing the self-evident strengths of the US with the less self-evident virtues of alternatives such as catastrophic Russia or stagnating Japan or the rapidly flagging Eurozone.
Where does that leave everyone else?
And it’s here that I want to address another fallacy. Namely, that the soaring dollar spells death and disaster for the home economies of rival currencies, and for what we loosely call “emerging markets” in general.
Oh come on now, you can’t have missed it. “Strengthening dollar rattles Mexican bonds,” say the headlines. “Managers ponder Asian exposure as US inflows soar.” “Clouds gather over negative yields in Japan.” And so on.
But upon closer inspection, the trouble areas seem much more restricted than you might have supposed. Look away from Latin America – and avert your gaze from Russia and plummeting Turkey – and you may notice that things are actually a whole lot less unpleasant out there than you think. We may have heard Donald Trump thundering away about an imminent trade war with China, but even he is aware that behind-the-scenes pragmatism must rule the day.
The most pragmatic of those assumptions, of course, has to be that it will be China that coughs up the cash to buy all the Treasury bonds that Mr Trump’s tax reforms will require. And rather a lot of the private-sector finance for all those public US construction projects (roads, airports, railways and so forth) which Trump had originally promised to fund with state money, but which is now being farmed out to private sector investors instead.
If China decides not to bail America out, the logic goes, then Washington runs the risk of losing bond investment in a sea of unaffordable debt. Who knows, the extreme thinkers ask, it might even be necessary one day to “reschedule” some of that unaffordable bond debt in a way that doesn’t make it look too much like a Cyprus-style pseudo-default. (Remember that? Shudder.)
To which I can only say phooey. China holds well over $1 trillion of US debt, and that debt forms part of the backing and underpinning for its own currency, the renminbi yuan. Why would Beijing ever want to do anything that might undermine the value of its own foreign holdings? One of the really excellent things we can say about global governments holding each others’ bonds is that it binds them together in a web of “pragmatic” mutual self-interest. If that’s the shape of a more secure future, I’m all in favour of it.
Which is why I tend to side, a little reluctantly, with the über-bull Ken Fisher, who has been insisting for a couple of years now that nothing Trump can do will inflict permanent damage on the markets, because markets run on numbers and presidents run on campaigning bluster, and because pragmatism will always exert its corrective influence in the end.
But I’m guessing that Mr Fisher must be rueing his ebullience just a little bit, now that the President is coming good on some of his more extreme campaign promises. And that realisation, together with Trump’s peculiar ideas about how a trade and fiscal economy works, is enough to signal some caution. This is the twilight zone, where the usual cosmic rules don’t always apply. Will things change as the November mid-term elections approach? A year ago I’d have said definitely. But suddenly nothing seems quite so definite any more.