Unilateral currency intervention: Avoid at all cost

Policymakers must consider the consequences of sticking their nose where it does not belong

As the FOMC meets this week to review its policy stance, another issue continues to rear its ugly head.

Despite the denials and counter denials by various Trump Administration officials, the talk of unilateral currency intervention by the US Treasury just won’t go away.

Just last Friday, Larry Kudlow, the Director of the White House National Economic Council, told CNBC that Mr. Trump “ruled out any currency intervention” after meeting with his economic team.

Subsequently, Mr. Trump himself countered by telling reporters, “I didn’t say I’m not going to do something”, according to the Wall Street Journal.

All this back and forth is both amusing and not surprising from the current administration.

At the same time, unfortunately, this issue is critically important to the global economy, global trade and state of the world asset markets.

What is even more disturbing are the assertions that a unilateral currency intervention by the US policymakers can work.

In my opinion, nothing could be further from the truth and, for the sake of global trade and economy, it should be avoided at all costs.

Currency intervention is nothing new. It has been practiced off and on by numerous countries over the years. The US Treasury, for the record, has participated in several interventions over the years. And there is nothing wrong with bringing a little order to the currency markets when they are getting one sided and the economic consequences of big currency moves become intolerable for some countries. Even unilateral currency intervention itself has been tolerated by the markets. Just look at the Swiss Franc. The Swiss central bank has been working overtime for the past ten years to make sure the economic burden of a strong currency was tolerable, in turn blowing up its balance sheet disproportionately.

But unilateral currency intervention by the US authorities to effectively weaken the reserve currency of the world will be a totally different ball game, especially in the current global trade related concerned environment.

While it could certainly succeed, I believe the likelihood of success in the current global economic environment is modest at best. Even more worryingly, there is a significant case to be made that such an intervention may prove to be a catastrophic miscalculation and may take down the global trading regime.

More on that in a minute.

What is unilateral currency intervention and how would it work?

Typically currency interventions by the US authorities are conducted by the US Treasury using its Exchange Stabilization Fund (ESF) and executed by the Federal Reserve Bank of New York. Further, given the limitation of the size of the ESF, The Federal Reserve has shared the burden of large-scale foreign currency purchases in the past.

The Federal Reserve Bank of New York, on behalf of the Treasury will sell the dollar to buy a basket of foreign currencies, thus depressing the value of the dollar against a basket of currencies.

The logistics of interventions are fairly well established and can be unfurled rather quickly.

But several issues are important in this regard. The size of the ESF is controlled by Congress and rather small relative to the size of dollar flows in the world. So, if the US Department of the Treasury runs out of dollars in the ESF, it will require a greater allocation from Congress, or explicit help from the Federal Reserve to hold its foreign exchange (FX) purchases and obtain new dollars for further intervention.

Why avoid it at all cost?

While the logistics of a currency intervention is straight forward and routine, I believe this would be a catastrophic mistake.

Why? Because the whole world will interpret it for what it is: a unilateral escalation of the current trade conflict by the issuer of the reserve currency of the world using unconventional financial weapons.

While the initial intervention may succeed for a bit, make no mistake about it: global asset markets are not going to take to it well. In fact, the markets have had great difficulty dealing with the tariffs, effectively representing artillery fire in the global trade war. Just imagine how the markets would react to bringing out the nuclear cruise missiles, which is what unilateral currency intervention would be construed as in the trade war context.

The initial success will fade rather quickly as risky assets start underperforming and US and foreign investors look for a place to hide, with US Treasury markets as a likely destination. This would lead a  to additional dollar strength rather than the desired weakness.

A similar situation happened in August 2011 when US credit ratings were downgraded. Despite the increase in the perceived US credit risk because of the downgrade, perversely, the 10-year Treasury yield went lower as investors sold risky assets and headed for the Treasury markets.

US authorities could, of course, double down, and may even succeed in keeping the dollar lower. But even in that scenario, the damage to the markets and global trade would be enormous.

And for what?

The US economy is a domestic economy to boot. Foreign trade is a relatively small component of the overall economy. The gains from incremental weakness in the dollar would, in economic terms, be quite modest for the risk of unwinding the global trading system and the perceived lack of strength of the reserve currency of the world.

The risks would indeed outweigh the modest rewards.

Because the US is a domestic economy, for the most part, they would be better off convincing the Federal Reserve to cut rates more aggressively rather than manipulating the dollar directly. That in turn could get the dollar lower anyway.

So, please go ahead and harass Jerome Powell to your hearts’ content but leave the unilateral currency intervention to the Swiss. The US economy is better served by hewing to the meaningless adage – a strong US dollar is good for the US economy.

Important Information

Blog header image: BonninStudio / Stocksy.com

The opinions expressed are those of the author, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds, and is an indirect, wholly owned subsidiary of Invesco Ltd.

Krishna Memani serves as the Vice Chairman of Investments for Invesco. In 2009, Mr. Memani joined OppenheimerFunds, which became part of Invesco in 2019. Before he joined OppenheimerFunds, he was a managing director at Deutsche Bank, heading US and European credit analysis. Earlier, he headed global credit research at Credit Suisse; was in charge of high grade and high yield portfolios at Putnam Investments; and was a credit analyst at Morgan Stanley.

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