Currencies: A Weak USD Preference
Stephen L Jen (London)
We remain constructive on the USD medium-term. Our forecasts are unchanged.
[This is weird. The author gives ZERO resons for his bullish view and half a dozen for a weaker US$. - Larry Summers for treasury secretary under Kerry? Mish]
However, the risk is rising of a shift in policy preference towards a weaker USD under the next US administration. This poses the single biggest risk to our USD call.
What I am concerned about. The USD broke out of its 8-month range two weeks ago. In addition to oil prices, the key development is the rising risk that the next administration may try to encourage USD depreciation to keep the US current account (C/A) deficit in check. Recent comments by some Fed officials and Larry Summers suggest that concerns for the C/A deficit have risen to such a level that some policymakers may be thinking of leaning harder on the Asian central banks to let the USD fall.
We have held an out-of-consensus constructive view on the USD for some time. However, I am getting more concerned that, if the US labour market continues to struggle, and as the US economy decelerates next year, support for protectionist measures may rise, along with policy pressures for the USD to fall. If Mr Kerry wins the election, I believe the risk of more protectionism and a weaker USD preference will rise.
The direction of causality is key. There are two related, but distinct, questions we can ask about the US C/A deficit and the USD: (1) will the US deficit experience financing problems, and (2) how much will the USD need to weaken to normalise the deficit?
1. The directions of causality are opposite. Question 1 asks how a large C/A deficit may affect the USD; question 2 asks how the USD could affect the US C/A deficit. Although the USD and the US C/A deficit are clearly endogenous, this distinction is very important, because the capital account may (and often does) drive a wedge between the two variables. Debate in the market had been focussed on Question 1.
2. The focus of the debate on the USD has shifted toward Question 2. In recent weeks, the Fed’s comments (from Yellen and McTeer) and the speech by Larry Summers, shifted the focus of the debate to Question 2.
On October 21, Ms. Yellen commented on how the strong USD is preventing the C/A balance from improving, “Another factor that may be working in the same direction is the dollar, which has remained relatively high despite our large and growing trade deficit. A high dollar makes imports less expensive for us and makes our exports more expensive abroad, thereby undermining the demand for domestic output.” On September 9, she said that if the dollar’s value remains steady, it will widen the US C/A deficit even more. She said that any turnaround in the C/A deficit has to involve the dollar.
McTeer, on October 7, said that ‘over time, there’s only one direction for the dollar to go,’ and that’s lower. This had the effect, whether intended or not, of imparting a negative expectation on the USD’s future trajectory. To the extent some believe that the capital account has been driving the USD and the US C/A, comments like this should dampen USD expectations and could dissuade foreign investment in the US or encourage US investment abroad.
3. The Fed may not be trying to talk down the dollar, but the two Fed Presidents did. The fact that the Fed, as an institution, is not talking down the dollar does not change the fact that two credible policymakers did.
4. Larry Summers’ position is important. Mr Summers’ speech on October 3 is important. First, he said the US C/A deficit is rising, and will not self-correct without major discontinuity in the global economy. Second, he said rising protectionist pressures are dangerous, and might be avoided if the USD helps contain the C/A deficit and slows outsourcing. Third, Mr. Summers suggests countries outside the G-7 participate in a coordinated effort to let the USD correct. Some have dismissed his comments by arguing that he is not a current policymaker. However, Mr Summers is likely on the short list for a cabinet post in a Kerry Administration. He is also a well-respected figure in economics and financial markets. What he says matters.
5. A weak USD preference versus a weak USD policy. An explicit weak dollar policy is virtually impossible under the current administration: it runs against the philosophy of Messrs Snow and Taylor concerning the policymakers’ role in influencing the dollar and would likely have repercussions for US equity and bond markets and face pushback from Asia and Euroland. In a prospective second Bush administration, chances of a move to an explicit weak USD policy are extremely low, and are pretty low under a Kerry administration. But a weak USD preference may go a long way in nudging the USD lower. The only question is how intense this weak USD preference will be.
Risks to our USD view. IF the US adopts a weak dollar preference or an explicit weak dollar policy, one problem with this prospective ‘strong Asian currency policy’ is that the market will not be able to distinguish it from a ‘weak dollar policy’; the dollar index may be pushed further into under-valued territory (and EUR/USD can rise further), just to contain the US C/A deficit.
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