Currency cold war risks

March 27, 2017 01:00 PM

Currencies are a difficult concept for Americans to understand. Just ask President Donald Trump, who reportedly called his national security advisor at 3 a.m. one day in February to ask if a strong U.S. dollar was good or bad for the economy. The now ex-security expert allegedly demurred to an economist. 

Even an economist would have difficulty answering that question unambiguously. A stronger currency can increase citizens’ buying power, but a weaker currency can make a country’s exports more competitive.

Back in the depths of the Great Financial Crisis, though, when global inflation was essentially flat and unemployment rates were abnormally high, the answer to the President’s question would have been clear: most countries preferred to have a weaker currency, reasoning that it would boost international demand for its goods. This preference led to the trumped up (no pun intended) “Currency Wars” of 2010-2013, where countries flirted with beggar-thy-neighbor competitive devaluations and protectionist policies to boost their domestic economy, often at the expense of global prosperity.

Based on early comments from the administration, there’s a risk of a similar economic conflict breaking out once again. In just a two-week period, President Trump noted that the dollar is “too strong” against the Chinese yuan and “it’s killing us,” while White House trade advisor Peter Navarro accused Germany of using a “grossly undervalued” euro to “exploit” its trading partners. As a result of these comments and the actions of other G10 central banks, the analysts at PIMCO have dubbed the current FX landscape as a “Currency Cold War.” 

Much like the post-World War II Cold War of the 20th century, the primary conflict in the budding Currency Cold War centers around two superpowers: in this case, the United States and China.

Though the United States has refrained from taking that official step in writing, he and his surrogates continue to make vague threats about leveling the global foreign exchange playing field.

China, while relatively new on the global economic stage, has plenty of experience in political cold wars, as its enforcement of the so-called “One-China” policy and the ongoing dispute over various islands in the China Sea exemplifies. Indeed, China has successfully toed a difficult line thus far this year, allowing its currency to depreciate against most of its major rivals while holding steady against the U.S. dollar 
(see “Yuan playing the field”). 

What few casual observers realize is that China has been intervening in the currency market to “manipulate” the yuan’s value, but that the country has actually been propping up the value of its currency rather than devaluing it. If the United States opts to label China a currency manipulator in the coming months, the People’s Bank of China would have less incentive to spend this money to support its currency and the yuan’s depreciation could accelerate.

The true nuclear option would be direct protectionism, where U.S. tariffs are slapped on Chinese imports. While China would undoubtedly respond in kind, the U.S. has a large trade deficit with China, meaning that it has far less to lose in the event of an escalating trade war — though trade wars tend to harm both combatants. Viewed in this light, the Administration arguably holds the balance of economic power and could therefore extract some concessions from Xi Jinping and company in the coming months. 

That said, a fundamental feature of cold wars is that they’re inherently unstable. Only time will tell if the two superpowers can successfully de-escalate the conflict or whether it will deteriorate into a catastrophic trade war.

About the Author

Senior Technical Analyst for FaradayResearch. Matt has actively traded various financial instruments including stocks, options, and forex since 2005. Each day, he creates research reports focusing on technical analysis of the forex, equity, and commodity markets. In his research, he utilizes candlestick patterns, classic technical indicators, and Fibonacci analysis to predict market moves. Weller is a Chartered Market Technician (CMT) and a member of the Market Technicians Association.