Wednesday, 10 January 2018

End of Strong USD ? Time To Shun Export Counters ? Not So Fast

Publish date: 

1. Introduction

Yesterday, one forum member wrote an article calling for people to shun export counters due to recent softening of USD. I do not really agree with that view. On the contrary, I believe recent developments point to possibility of further strengthening of USD in coming months.

2. Trump's Comments

The recent softening of USD was caused by Trump's comments few days ago that "USD is too strong". That was actually the second time he said something like that. Few months ago, Trump said "strong USD is killing us". As a knee jerk reaction, USD softened for few days. But it subsequently rebounced. Don't be surprised if the same thing happens again.

3. USD and Presidents

The reason why currency markets reacted to Trump's comments is because there is belief that US Presidents hold great sway over the direction of USD. Mark Möbius made such a comment few months ago, "When a U.S. President wants the USD to move in one particular direction, he always get what he wants." Mark Möbius is a seasoned investor. A very wise and credible person. What he said should not be simply brushed aside. With that in mind, I did a quick study of how US Presidents had intervened in currency market in the past to influence the direction of USD. 

4. Obama and Quantitative Easing

As we all know, in the past few years, the Obama Administration embarked on so called "Quantitative Easing" which essentially involved printing money non stop. With huge increase in supply, the USD softened substantially over the past few years.

At first look, it seem that the U.S. President can in fact determine the direction of the USD. He did that by playing with monetary policies. However, if you think a little bit deeper, that was not really the case. I would argue that Obama was able to bring down the USD because it was in line with the macro trend. The U.S. was stuck in a recession and inflation was low. This created a conducive environment for him to undertake his Quantitative Easing. 

To sum it all up - a US President, no matter how much policy levers he has, has to operate within the system, which is driven and determined by market forces. In such a system, the President cannot single handedly determine the direction of the USD. What Obama has done is to follow the major trend and amplify the effect.

5. Plaza Accord

Another very famous case whereby the US government intervened to bring USD down was the Plaza Accord. In the 1980s, the USD was very strong. Naturally, that resulted in high trade deficit and loss of export competitiveness. The U.S. government was very unhappy about that. In 1985, the leaders of 5 countries - US, Britain, France, Germany and Japan met in Plaza Hotel in New York City. At the end of the meeting, the five countries agreed to cause the USD to depreciate. Over the next two years, the USD depreciated by closed to 50% against the Japanese Yen (and weakened against other currencies also). 

50% depreciation over a period of two years !!! Isn't that another proof that the U.S. President can single handedly determine the direction of the USD ?

Nope. If you take a closer look at the details of how it was done, you will realise that it was not as simple as that.

The depreciation of USD pursuant to Plaza Accord was achieved through COORDINATED actions by the five governments. Please refer to the following information extracted from Investopedia : 

"Germany agreed to tax cuts, the U.K. agreed to reduce its public expenditure and transfer monies to the private sector, while Japan agreed to open its markets to trade, liberalize its internal markets and manage its economy by a true yen exchange rate. All agreed to increase employment. The United States, bearing the brunt of growth, only agreed to devalue its currency."

The insights I gained from studying the Plaza Accord is that to drive down the USD, you require the cooperation of other countries and central banks. They will have to drastically change their macro economic policies so as to cause the currency market to move in the targeted direction. Words cannot achieve that.

The U.S. was strong enough in the 1980s to force its allies to undertake such drastic changes. That was because they all sought safety under its security umbrella against the threat of Communism. In today's world, if Trump really wants to depreciate the USD, it needs to work with China, its biggest trading partner. Can the US President force China to change its macro economic policy to pull off another Plaza Accord ? The answer is a definitive "No". China is no Japan. It does not rely on the US for security. It is also big and strong enough to resist coercion. Another Plaza Accord is simply impossible. 

6. The China Factor

In 2016, US registered trade deficit of more than USD350 bil with China. Trump complained loudly about that. On 7 April 2017, Xi Jinping indicated to Trump that China is willing to work with him to reduce the deficit. They have kicked start a 100 days process to sort out the details. 

I believe Xi is sincere in giving some concession to the U.S. This is because China needs another 10 to 20 years to outgrow the US. It is willing to cede some ground now just to get Trump off its back. It is unlikely that the talks will result in elimination of the entire USD350 billion deficit. But a reduction of even USD100 billion could be a big win for Trump, which he can tweet until his fingers fall off. China can do that without hurting itself much. For example, instead of buying soybeans from the Brazillians, they will buy more from the State of Iowa. Or maybe buy some shale oil, now that US has started exporting this commodity.

In my opinion, in the event that the reduction in trade deficit happens (which is very likely as China is fully capable of delivering USD100 billion), the currency market will go crazy. USD will strengthen substantially, probably to level we have never seen before.

7. Concluding Remarks

According to my study, it is only partially true that the U.S. President can influence direction of USD in a significant way. In Obama's case, he managed to guide the USD down in line with the macro trend. But now the U.S. is more or less out of recession and enjoying strong employment. Whoever the President is now, he has lost that flexibility to print money. It will cause inflation to spike. Instead, the general trend now is to tighten up. We can forget about using QE to press down the USD. It won't happen.

As for Plaza Accord type maneuver, it requires cooperation by U.S.' major trade partners. Back in the 1980s, the U.S. government can pull it off by arm twisting its junior allies. But this is not possible now with China. It simply won't play balls.

Now that we have eliminated the possibilities of the above two events happening, what is left is the macro economic factors. Many of the bullish factors that support strong USD (strong employment, potential rate rise, potential tax cut, massive infrastructure spending, etc) are still in place. On top of that, one major catalyst will be if China really deliver concession to reduce trade deficit, the USD will be on steroid and run wild.

In my opinion, it is still too early to call the end of USD rally.

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