Intervention: Huff, Puff, and Bluff

Economists, strategists, and reporters continue to have a difficult time getting a handle on the disruptive American President. They insist on taking seriously every feint of a person who appears to relish keeping his friends and adversaries off-balance. One continues to fuel a discussion that is generating more heat than light. Previously, Trump accused one or another country of currency manipulation. Yet, his own Treasury Department, which has softened the criteria, has not cited a single country, though a watchlist has been expanded.

It was the presidential tweets on July 3 that sparked the controversy. Trump repeated his accusation that China and Europe were manipulating their currencies to America's disadvantage, but added a threat of sorts: "We should MATCH them or continue being the dummies who sit back and politely watch as other countries continue to play their games." Many took it as a threat to intervene in the foreign exchange market to drive the dollar down, though, in fairness, it fits very well in his campaign to get the Fed to cut rates, as well. In fact, the ECB did not materially intervene in the foreign exchange market, and by all reckoning, the action by the PBOC was to slow its descent. To "match" them could be very well in interest rates than in material intervention.

The conventional wisdom that emerged among analysts was that the near-term probability of intervention was small, but it was increasing. Balderdash. What is the evidence that the risks are increasing? Participants did not sell the dollar or demand a greater risk (volatility) premium. The US dollar has risen against the major currencies but the dollar-bloc this month. Three-month implied volatility is just above five-year lows, and a week after the controversial tweets that riled analysts, 12-month volatility was at its lowest level in a dozen years.

If it was a threat to intervene in the foreign exchange market, why would the threat become more potent over time? That begs the question, does the threat make it more likely objectively, or is that really just analysts' short-hand that they had not considered that scenario previously? Now they will have to think out it more than in the past, and therefore it is a more important risk in their informal models.

The decision to intervene in the foreign exchange market is made by the President through the US Treasury. The Federal Reserve executes the order using half of its funds and half of the Treasury Department. The Federal Reserve has an unlimited amount of dollars, while the Treasury has a limited amount of dollars (~$25 bln) in the Exchange Stabilization Fund.

Mark Sobel, a long-time and highly respected US Treasury official (now US Chair of OMFIF, an independent forum on central banking, public policy, and investment) wrote a persuasive explanation why intervention would be disruptive. The usual criteria for intervention--disorderly market or extreme valuation- do not appear present, he argues, and the operational challenges are formidable. What currencies should be bought? How large of an operation would be required? Does unilateral intervention work?

The collective wisdom of the markets is that the risk of US intervention remains nearly negligible and that the strategists and reporters are getting too excited. It is a bluff to which investors have paid little mind. Although the nationwide opinion polls show several Democrats leading the incumbent president, many economic-driven models suggest Trump still has the advantage. It also seems that the President puts much emphasis on the stock market performance as a heuristic metric.

The operational risks bring to the fore the challenges to a successful operation. But the opposite is also true, successful intervention may be counter-productive. Intervention that succeeds in driving the dollar down could drive interest rates higher as investors demand to be compensated for this exchange rate risk. Rising interest rates could also encourage the liquidation of equities.

If it were not for the analysts and the media, the tweets would have been consigned to twit heaven. It is not just that investors did not bite, but other officials have not either. For it to be a provocation, someone has to be provoked. In none of the accounts I read has anyone noted the absence of an officials response: This is also why claims of a currency war still ring hollow. Trump is being given a wide berth.

The argument here is parallel to the one that plays down the encroachment of the Federal Reserve's independence by Trump's repeated public badgering. A recent Wall Street Journal poll found that slightly more than half the economists surveyed saw little or no impact on the Fed's ability to make policy decisions independent of political pressure, and another 42% saw the Fed's independence only "modestly" undermined.

Intervention by the US would come as a shock and have an immediate impact. We suspect the element of surprise and signaling function would spark a disruption, even if a relatively small amount was deployed. The right information relayed to the interbank dealers, such as the trade not being for a commercial transaction, for example, could create a multiplier effect. There would be far-reaching implications of weaponizing the dollar. Other countries may respond in kind or seek to neutralize the US attack. A genuine currency war could be triggered, which is much different than countries pursuing appropriate monetary policies that so many still insist on calling a currency war. It could hasten the decline of the dollar to the first of equals rather than the dominant currency.

Rather than increase over time, the risk of US intervention may decline as the Federal Reserve begins cutting interest rates. The market is convinced that there will be at least two cuts this year and maybe "data dependent" on a third. Par for the course, the American President may have manufactured a crisis and can declare victory. St.Louis Fed President Bullard, who provided the first dissent under Powell, claimed last December's hike was a mistake, which is what the President has been arguing. A plummeting dollar on the back of intervention could frustrate Trump's campaign for lower interest rates.

When it comes to a material war, the US President has much discretion. The same is true of a currency war. We agree with investors, and most analysts, in seeing the risk of imminent intervention as being remote and negligible. We disagree that the odds are increasing going forward. Nor do we accept that Trump's comments triggered or inflamed a currency war as the silence of others is deafening. Do not be distracted by the feint. If measured as a product of credibility and capability, the biggest risk to the dollar is not intervention, but the continued weaponization of access to it that is encouraging allies as well as adversaries to look for alternatives.