FX Weekly: Have the currency wars reignited?

Does the US pursue a strong or weak dollar policy? Does it even have a policy on USD? In the last few days it’s become rather hard to tell precisely what the US administration desires after a week of mixed messages on its currency. Meanwhile Treasury Secretary Mnuchin’s comments appeared to annoy the European Central Bank and there was even mention of (whisper it), currency wars.

Mnuchin gives dollar bears ammunition, Draghi brings a spoon to a gun fight

The dollar has been on the back foot for some time, but there was fresh cause for traders to sell greenbacks after Treasury Secretary Steven Mnuchin apparently broke with 25 years of the ‘strong dollar’ mantra that every administration has stuck to since Robert Rubin. 

“Obviously a weaker dollar is good for us,” he said in Davos. Traders took this a sell signal and dumped USD – although quite why they thought it amounted to a reversal in US policy or an indication that the administration would actively seek to devalue the dollar was unclear. He’s certainly not the first Treasury Secretary to suggest that either the buck is a little strong for comfort or it’s nice and weak, thank you very much. Rubin did it, Paul O’Neill did it. Larry Summers even sold dollars to support the euro. But there is something altogether different about the backdrop to this ‘off-script’ message as it comes amid very real concerns about protectionist trade policies being erected.

USD has been tanking for a year for a number of (sometimes contrary) reasons, but Mnuchin was the ammunition for more selling.

As Larry Summers noted in his FT piece, there is a difference between expressing realities (a weaker USD will boost exports, all else being equal), and communicating a radical change in policy. Indeed the very next words uttered by Mnuchin were very much for the status quo – “longer term, the strength of the dollar is a reflection of the strength of the US economy”.

Nevertheless the ECB didn’t much like any of this and pretty much called out the Trump administration for potentially, perhaps inadvertently, starting a currency war. Speaking on Thursday, Mario Draghi offered a mild but clearly stated rebuke, explicitly referencing G20 and IMF agreements in saying that the ECB will “refrain from competitive devaluations and will not target our exchange rates for competitive purposes”. Handbags but it was clear that the Governing Council was unimpressed.

Draghi added later:  “Yes, there was concern, several members expressed concern and this concern was also – in a sense was broader than simply the exchange rate. It was about the overall status of international relations right now. So the answer to your question is yes; we are concerned.”

By this stage the dollar was looking very wobbly and it’s not too much to say that there was (is) genuine concern about a rift between the US and the major European economies on currency communication.

Trump talks

Cue the big man. With Trump in Davos he used an interview with CNBC to repair some of the damage done by Mnuchin by arguing – probably correctly – that his Treasury Secretary’s comments were taken out of context. “The dollar is going to get strong and stronger and ultimately I want to see a strong dollar,” he said. The USD leapt on the remarks before easing back close to the lows hit earlier on Thursday.

But does the US desire a weaker dollar? Trump may want to ‘weaponise’ the dollar to get other countries to accept his ‘America First’ trade policies and has previously said he didn’t like the strong dollar – saying over the last year that it is ‘too strong’ and that ‘lots of bad things happen with a strong dollar’. He should be careful what he wishes for – it can be tough to talk a currency back up, tougher than talking it down at any rate. We’ve been here before in the early Clinton administration era, when remarks about a weaker dollar resulted in a broader sell-off in US assets.

Whether the US does or doesn’t seek a weaker dollar to promote exports and rebalance the deficit, the worry is that this kind of thing starts, albeit inadvertently, a slow but steady stream of countries seeking competitive devaluations of their own.

No wonder the ECB is concerned – but not that concerned by the current level of the euro it seems. If Mnuchin really did fire the first shot in a new round of currency wars, the Draghi brought a plastic spoon to the pistol fight. His presser resulted in a spike in EURUSD which even the Trump intervention has failed to quell.

Commenting on the recent euro volatility, he said that it is a source of uncertainty that requires monitoring with regards to the medium term outlook for price stability. However there was no explicit reference to the level, just the volatility. This is by and large what all central bankers say as they don’t like wild swings in their currencies. If he had really wanted to take the euro down a peg or two he would have talked about the actual level more than just the volatility. This was taken as a fairly bullish signal, as was the assertion that the ECB has increased confidence that inflation will converge with target. Still the ECB does not appear to be moving especially quickly or any faster than markets currently expect. Keep an eye on inflation – if euro appreciation is deflationary then the ECB could be forced into an awkward spot. The pool of available bonds to purchase is running out. Nevertheless I think there could be some upgraded inflation projections in March that Draghi can use as his cue to exit the QE party.

Trade and protectionism

We have to see Mnuchin’s remarks in a wider context and particularly the Trump administration’s attitude to trade. We have seen the first tariffs imposed on South Korean washing machines and Chinese solar panels. There could be many more to come and we should learn more over the coming days whether protectionism leads to more rifts between the US and Europe. Ultimately this could feed into a weaker USD and a broader selloff in stocks and bonds.

While next week sees the release of PCE inflation numbers (Monday) and on Wednesday the Fed’s first policy statement of the year (and last for Janet Yellen), the weaker-dollar mantra and concerns about protectionist policies are likely to dominate market focus with regards the USD. Inflation may rise (core CPI in December was strong) and that could boost expectations for more hikes from an FOMC that is looking more hawkish this year than that any time under Yellen. This may push up the yield on US Treasuries but that has failed so far failed to push up the dollar. The State of Union address on Jan 30th could tell us more. (At the time of writing, Trump is yet to deliver his Davos speech).

If protectionism spreads, why not devaluations? A trade war would easily beget a currency war – in fact the latter may necessarily follow the former if countries see their economies impacted by trade barriers. Mnuchin’s remarks may just have started something that is not easily stopped.

EUR/USD

EUR/USD seen consolidating in $1.24-25 range

Focus on trade, Fed and PCE inflation next week

Looking ahead, preliminary flash GDP figures for the Eurozone are due Tuesday, while the all-important core CPI estimates are released on Wednesday. This will show whether inflation is converging with the ECB’s target – a key requirement for the central bank to start reducing stimulus – or if it remains lacklustre. A poor core CPI number could at least slowdown the EUR juggernaut.

Turing attention to the US, the Fed’s preferred measure of inflation, the core personal consumption expenditures (PCE) index, arrives on Monday. The data is the last of any real importance before the Federal Reserve convenes this week and will be important for shaping market expectations for Fed policy this year.

Core PCE has undershot the Fed’s target since 2012 and the persistent lack of inflation last year surprised many. But the most recent CPI inflation figures may suggest we’re in for an uptick. The Labor Department’s core CPI reading rose 0.3% in December, the biggest advance in 11 months. It means core CPI rose 1.8% in 2017, up from 1.7% in the 12 months through November.

Nonfarm payrolls are also due on Friday next week but increasingly these are playing second fiddle to the hard inflation data given the apparent breakdown in the link between employment, wages and price growth.

Levels to watch

Having whipsawed on the Mnuchin-Draghi-Trump rollercoaster, EUR/USD appeared to be ending week consolidating in the $1.24-25 range.  For bulls a break past $1.2538, Thursday’s high, calls for $1.26, the 61.80% retracement of the move from the $1.40 (2014 peaks) to $1.03, the low of Dec 2016.

On the downside, a fall below $1.24 could take us to $1.2320, which could suggest $1.2160 - the key level as this marks the recent lows tested on January 18th and is the 50% retracement of the aforementioned move from $1.40 to $1.03. Strong euro fundamentals may well prevent a move to $1.2160 resulting in anything more substantial but it could certainly derail the current uptrend and result in more sideways moves.

GBPUSD

Cable creeps over $1.43

Uptrend continues

The cable continues to creep higher largely on USD weakness. Better-than-expected UK employment data on Wednesday did however offer traders a reason to be buying sterling rather than simply selling dollars. On Friday a decent GDP print saw sterling recover more Trump-inspired losses. The UK economy grew 1.8% last year – not bad but still very much in the slow lane. The 0.5% expansion in the fourth quarter was better than expected. However, GDP numbers are always backwards looking however so the reaction in the markets was muted.

Levels to watch

Cable hit a high at $1.4345 on Thursday but the strong dollar comments from Trump drove it back down, where it found support at 1.4083.

A move below $1.40 could mark the end of the rally and calls for a move to 1.38580, the 61.8% retracement of the pre-Brexit high to post-Brexit low. On the upside if the momentum is sustained the next big level after the high of $1.4345 is $1.4590, the 50% retracement of the move from $1.71 to $1.19.

USD/JPY

BoJ steady

Yen exposed to dollar softness

Markets were sensitive to Bank of Japan communication but ultimately Kuroda kept the easing bias intact. Pressure instead is coming from USD weakness which has pushed the yen to a new low at 108.500.

The BoJ left policy unchanged and governor Haruhiko Kuroda gave a dovish presser.

For now at least the BoJ has done a pretty good job of keeping the lid on the yen bulls. Inflation projections remained unchanged (1.4% in 2018 and 1.8% in 2019) although there was a slightly more upbeat tone than before. This is the same quandary as that facing the ECB – any suggestion of normalising will lead to further yen strength and that will result in de facto premature tightening, making the BoJ’s eventual exit even further away. As markets weigh a possible early taper Governor Kuroda pledged to remain fully committed to easy money and said there was no discussion about an exit or ‘stealth taper’. His comments reassured markets and put a floor under USD/JPY – until Mnuchin waved his magic wand.

Levels to watch

The 50-day simple moving average continues to approach the 200-day and a break below could be a trigger for selling momentum to pick up.

For the time being USD/JPY is finding some support around the 109 level but a break below Thursday’s low of 108.500 calls for the 107.300 area, last September’s low. We then see longer-term support on 106.5, the 38.2% retracement of the Oct 2011-May 2015 rally, beyond that the next support is Jun-Sep 2016 lows at 100, the 50% retracement of that move and significant psychological round number support.

On the upside, 110.150 marks the 61.8% retracement of the Sep-Nov rally and looks like offering pretty firm resistance. A move back here could mark a chance to have a pop at 111 again and the 111.500 area, the 38.2% retracement of the Dec 16- Sep 17 fall from 118 to 107.

Beyond there we have long-term resistance around 114/114.2, which is around the 23.61% retracement of the move from 75 to 125 (Oct 11 – May 15) and the 61.8% retracement of the 118-107 move discussed above. This has proved very strong resistance, with USD/JPY bouncing off this level on three occasions in the last 12 months in May, July and November.