It is understandable that all focus may be on equity markets in the aftermath of a 1,500-point drop in the Dow Jones Industrial Average. The sequence of triple-digit down days over a recent four-day period (down 335 points July 31, down 300 points August 1, down 100 points August 2, and most notably down 750 points Monday, August 5) is dramatic, uncommon, and deserving of an explanation. Yet it is not sufficient to say, “once we evaluate the equity market we should also look at fixed income markets and currency markets,” for indeed, understanding what is taking place in global currencies and global rates is a prerequisite to analyzing the state of risk assets.
The announcement (via Twitter) last Thursday that the trade talks with China had (again) broken down, and that 10% tariffs were being implemented on $300 billion of additional imports was unsettling enough. However, the subsequent (though not surprising) news that China was devaluing the Yuan represents an entirely new source of market distress. Keeping the pattern going, the announcement that the U.S would label China as a currency manipulator may not have shocked every market pundit, but it added layers to the uncertainty and vulnerability of global capital markets.
Foreign exchange volatility is not new in modern finance, though relatively speaking it has been reasonably muted in recent decades compared to preceding ones. Uncertainty around foreign exchange suppresses business investment in that the ability to repay debt from a capital project cannot be quantified when the value of the currency it will be paid back in is unstable and subject to massive fluctuation in value. It would be like trying to set a weight loss goal but you know that the scale you will use to measure results is significantly unreliable (in both directions); there is no real point in getting serious about the diet and exercise unless a working scale can be found. Risk assets all benefitted when a coordinated effort was made (worldwide) to limit the volatility of currency movement.
The reasonably smooth ride in global currencies has not come without exceptions. In 1987, Treasury Secretary, James Baker said that the U.S. would not cooperate with other countries creating divergent rate policy from our own. The next day was Black Monday, October 1987. We know of the global distress created in 1997 when the Thai Baht lost its peg to the U.S. dollar. The Russian Ruble created a similar spike in volatility in August of 1998. More recently, China’s seeming abandonment of its Yuan support in August 2015 caused a spike in capital outflows and tremendous anxiety in global risk assets. In hindsight, some of these incidents look globally insignificant, but none felt that way at the time. All of them share the fundamental story of calling into question the ability of one party to meet debt obligations (denominated in a currency that had turned negative). And all of these stories share the contagion effect of undermining confidence in global capital markets.
When central banks around the world coordinated in February 2016 to calm currency markets and address Chinese capital outflows, the result has been 40+ months of very low currency volatility (combined with very low-interest rates, of course). What could a risk asset investor love more? The delta between the U.S. dollar and the Chinese Yuan has recently reached that late-2015 level, though, spurred on by the Trumpian trade war and tens of billions of dollars of tariffs distorting trade economics. The February 2016 arrangement looks vulnerable at best and obsolete at worst. What could a risk asset investor love less?
China has plenty of economic headwinds which could force them to weaken their currency even apart from the trade conflict with the United States. China has few options for combatting the impact of the trade battle, and currency adjustment is the easiest tool at their disposal to soften its deleterious effect on economic growth. But a very important understanding must be had – China’s actions right now are not actively weakening their currency, as much as backing off of their actions to prop up their currency. Indeed, China has been “propping up” its currency for years (in its own best interests, of course). China does not meet the three-prong criteria of a currency manipulator, even though they certainly would be willing to do so if it were in their best interests. “Not intervening to support one’s currency” is hardly the same as “intervening to weaken it,” and while there is no doubt China’s motivations for acting (or in this case, not acting) is to effect their currency in a way that advantages them relative to the trade dispute, active currency retaliation by the United States would be extraordinary in this situation.
How can the United States “manipulate” its currency? Besides years and years of central bank bond-buying (quantitative easing) and aggressive easing of their target rate, a more direct currency intervention has become a real conversation for the first time in decades. Should the White House order the Treasury Department to buy foreign currencies in direct proportion to what others are buying of the U.S. dollar, it would undermine the dollar’s appeal as a reserve currency, and certainly weaken demand for U.S. assets. Furthermore, the ability to even do that (aggressive in its own right) is limited by the amount of money appropriated to the Exchange Stabilization Fund. The option of declaring a “national emergency” and ordering the Federal Reserve to sell dollars would be a “code red” of historic proportions.
Currency clauses may very well appear in future trade deals. Markets would appreciate such stabilizing forces in the world of global currency. But we should expect more turbulence until there is greater clarity on how aggressive each side intends to be in what has become a threatening currency war. What is at stake for risk assets is not merely one outcome or another in the trade war, but the risk of a permanently damaged scale when measurable weight monitoring is the need of the hour.
This week’s report features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
