One Bank Warns Direct US Currency Intervention Is Increasingly Possible

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Here's a "shocker": Donald Trump is right about the dollar being overvalued.

In attempt to answer the ongoing debate about whether the USD is overvalued relative to its peers, in a lengthy report from Bank of America's Ben Randol and Adarsh Sinha we read that the simplest gauge is to compare the real effective exchange rate (REER) to its long-run history, which shows that it is about 13% above its long-term average...

While according to more sophisticated techniques from the International Monetary Fund (IMF) show that the dollar is overvalued by 8-16%. In the recently published Semiannual Report to Congress, the Treasury cited the IMF research and pointed out that the 4.5% dollar appreciation over 2018 is concerning, and that sustained dollar strength would likely exacerbate persistent trade and current account imbalances.

Taking a step back, BofA notes that a classic textbook definition of long-run valuation is that the exchange rate is in 'equilibrium' if it does not cause internal and external imbalances. That is, there is no output gap or inflationary pressures domestically, and the current account is sustainably financed via capital flows externally. In the short- to medium-term, however, exchange rates can deviate from equilibrium by considerable magnitudes and for a period of many years.

Thus, while the dollar might be overvalued, it may not be necessarily out of line with fundamentals. The US is growing at a faster pace than many of its trading partners, therefore supporting dollar strength. In addition during times of heightened uncertainty - owing in part to the threat of tariffs - the dollar is underpinned by safe-haven flows. It is therefore important to understand the reasons for short-run fluctuations around the long-run fair value.
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Whatever measures one uses, however, it is clear that the dollar is currently "overvalued" and Trump is clearly pissed about it, arguing time and again that the strong dollar is "unfair" for one simple reason: the strong dollar stands in the way of his goal to boost exports and support the US manufacturing sector. 

So what can Trump do about it? 

For one, he could encourage the Federal Reserve to ease policy - something has has been doing rather deliberately on his twitter account and in other media - thereby weakening the dollar. The Fed has shifted and is guiding toward cuts but with limited impact on USD so far.

Another option is to "talk" the markets into weakening the dollar. In the beginning of his administration, this proved to be successful but there appears to be diminishing effects as the chart below shows.

So if verbal intervention is no longer an option, BofA cautions that the risk is that the focus moves to formal currency intervention, and while this is not Bank of America's baseline expectation, "the risks are rising."

If not Trump, what would the Treasury do?

At its simplest, BofA writes, "the US Treasury - which is responsible for international financial policy and therefore managing USD - will guide the NY Fed's market desk to intervene." So, if the goal is to weaken the dollar, the NY Fed would sell dollars and buy the other currency. The currencies that are used for intervention come from the Fed's holdings and the Exchange Stabilization Fund of the Treasury, which largely consist of euros and Japanese yen.

There are two types of interventions: sterilized and unsterilized. 

When the intervention is sterilized, the NY Fed will buy or sell other securities (e.g. sovereign bonds) through open market operations. This prevents the intervention from changing the monetary base and interfering with monetary policy. The composition of the Fed's portfolio is altered, however. When the intervention is unsterilized - which is more typical - it has the ability to influence the money supply and impact interest rates.

What is the history of US currency intervention?

From the 1970s to the mid-1990s, the US frequently intervened in the FX market in an attempt to stabilize an otherwise volatile dollar, especially against the DEM.

The late-1970s marked a period of aggressive intervention given that the dollar was under heavy pressure and depreciated on the back of high oil prices, high US inflation and widening deficits.

There was also a strong case for intervention in the mid-1980s when the G5 countries (the US, Germany, Japan, Britain, France) met at the Plaza Hotel in New York, and decided that the US dollar was "overvalued", agreeing to bring the dollar down by 10-12% through coordinated central bank action (aptly known as the "Plaza Accord"). The intervention following the meeting was successful: by the end of 1986, the yen, deutschmark, and British pound had all appreciated by 40-50% vs the dollar.

The 1990s marked the final stage of big dollar interventions. Between 1991 and 1992, the Treasury and the Fed intervened in the face of a weakening dollar on the back of the Gulf War. Once again, the US was faced with a weak dollar in 1994 and the US intervened repeatedly, coordinating with the Japanese and individual European central banks to support the US currency. Since 1996, however, the US has only intervened three times, according to NY Fed data: buying Japanese yen in June 1998, buying euros in September 2000, and selling Japanese yen in March 2011.

Is US currency intervention legal from an international perspective?
The most recent G20 Communique from earlier this month, to which the US is a signatory, reaffirmed commitments made in March 2018 regarding exchange rates. That statement reads as follows.

Flexible exchange rates, where feasible, can serve as a shock absorber. We recognise that excessive volatility or disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will refrain from competitive devaluations, and will not target our exchange rates for competitive purposes. - Communique, G20 Finance Ministers & Central Bank Governors, March 20, 2018

While the G20 countries have agreed not to target exchange rates for the purpose of competitive devaluation, the text recognizes undesirable effects that could be caused by volatile exchange rates. This means that temporary intervention for the purpose of stabilizing FX is permitted. So while the statement provides possibility for intervention under the auspices of countering volatile markets, the currently low level of FX volatility would argue against this being a relevant argument at this point. If risk-off conditions precipitate a legitimately disorderly rise in USD, however, BofA thinks "the probability of intervention by the Trump Administration increases significantly."

What do other countries do?

The geographically smaller and economically open financial centers such as Switzerland, Macao, Singapore and Hong Kong have been the most active in currency intervention. This is because exchange rates in these areas have an outsized impact on the economy because of their importance to overall financial conditions. Among these, Switzerland intervened in its currency for all three years between 2015 and 2017, with net official flows averaging 14% of its GDP. This was conducted entirely by its central bank. Meanwhile, Singapore's action materialized through its public pension system by investing income taxes entirely overseas through a sovereign wealth fund. Japan also increased the share of public pension fund investment in foreign assets between 2012 and 2016, resulting in a net financial flow of more than 4% of GDP.

Outside of financial hubs, currency intervention is also commonly found among manufacturing exporters to boost their competitiveness. For example, both Taiwan and Israel intervened in their currencies for all three years between 2015 and 2017, according to Peterson Institute research.

Emerging markets' central banks also have a history of intervening, largely with the goal of smoothing FX volatility. In good times, they have tended to accumulate USD reserves (pushing down the value of their currencies) to self-insure against periods of infrequent but severe global risk aversion, where capital-flight risks necessitate selling USD to prevent currency depreciation that would jeopardize their inflation-targeting mandates. Although China had been the largest currency intervenor a decade ago, it actually did the opposite in 2015 and 2016. Instead of buying, China sold large amounts of foreign assets to prevent its currency from depreciation on the back of capital flight.

Finally, the all important question: Does intervention work?

The answer will depend on the intention of the intervention. If the goal of intervention is to stabilize exchange rates, the evidence suggests that intervening proves successful. This is particularly the case in emerging market countries where the financial system is less developed. Moreover, token or temporary interventions can generate meaningful signaling effects, helping to underscore easier monetary policy and support the economy.

However, if the goal is to achieve a targeted long-term level of competitiveness, the literature generally finds that unsterilized intervention does not work because the increase in relative inflation offsets nominal FX depreciation (just look at Japan's decades of failed direct intervention which eventually became targeted by the amrket). It also could have negative side effects as it creates distortions and could work against other policies if not coordinated properly with the central bank.

History shows that currency intervention is a useful tool for emerging market countries which need to stabilize exchange rates. But there is little evidence that it works for advanced economies with the intention of targeting long-term FX competitiveness. Which may be precisely why Trump will try it...