Daily Comment (July 20, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] There is a lot going on.  Let’s dig in:

The president speaks: For the most part, President Trump has been opposed to a weak dollar.  At Davos this year, Treasury Secretary Mnuchin suggested a weaker dollar might be in U.S. interests if the goal was a narrower trade deficit.  President Trump publicly criticized Mnuchin’s comment, suggesting the dollar should be strong.  For many Americans, currency markets are something of a mystery.  Unlike consumers of other countries, Americans are mostly insulated from dealing with exchange rates.  We note that President Reagan was supportive of a strong dollar until it reached a level that became unsustainable.  In response, at the Plaza Hotel in NYC the G-5 adopted the “Plaza Accord,” which was a multi-lateral policy shift to deliberately weaken the dollar.

We may be seeing a shift.  This morning, on social media, President Trump openly criticized the EU and China for currency manipulation.  The dollar has plunged on the news, while gold and other commodities are higher.[1]  Although it’s difficult to know for sure, this development could be quite significant.  Tariffs, by themselves, are dollar bullish as they reduce the supply of dollars on world markets (see this week’s Asset Allocation Weekly below).  But, if the president has figured out that foreign nations are allowing their currencies to depreciate in order to offset tariffs, and he begins to jawbone the dollar lower, we will likely see a declining dollar.  It should be remembered that the dollar is overvalued by most valuation metrics, so an official weak dollar position could find a path of little resistance.

But wait…there’s more!  However, this isn’t the only thing the president has said over the past 24 hours.  He also indicated he is ready to slap $505 bn of new tariffs on China.[2]  We note that the National Economic Council’s director Larry Kudlow has noted there are no talks with China.  There is a school of thought that China may be concluding that the GOP will lose the House in November.  If that’s the case, President Trump will find himself dealing with everlasting investigations and thus will be less able to prosecute a trade war.  We note that the prediction markets are projecting a change in control for the House.

(Source: PredictIt)

If China has taken this position, then it would make sense for the Chinese to simply stall until November and then see U.S. trade policy moderate due to distractions at the White House.  Of course, the administration can do this calculation as well and may try to force an agreement.  Although it is still not clear whether this is really China’s policy, it makes sense to us and thus we would not be surprised to see mostly silence from Beijing.

Trump and the Fed: As noted above, the dollar has been strong this year.  As we noted in this week’s Asset Allocation Weekly (see below), one of the factors boosting the greenback is the potential for a trade war.  Rising tariffs, in theory, are bullish for the dollar because they act as a constraint on dollar supply.  U.S. monetary policy is another factor that has supported the dollar.  The Fed has been steadily raising rates when the rest of the world has mostly been holding to accommodative monetary policy.

One of the factors we have been monitoring is the White House’s position on monetary policy. Earlier this year, Larry Kudlow, the director of the National Economic Council, hinted that the Fed shouldn’t raise rates due to fiscal stimulus because the tax cuts would boost investment and thus add to productive capacity.  Although that point is debatable (as we noted in last week’s AAW, it appears the tax cuts may be going to stock buybacks), the bigger issue was the interference in monetary policy.  During Bill Clinton’s presidency, Robert Rubin, who became his treasury secretary, convinced the administration to avoid commenting or criticizing the conduct of monetary policy.  The idea was that if the White House allowed the Fed to run policy and bring down inflation, the decline in long-term interest rates would be the best stimulus the economy could receive.  Since then, the unwritten rule has been that administrations leave the Fed alone.  And, for the most part, they have.  Despite what you are seeing in the media,[3] prior to Rubin’s directive, administrations often commented on, or overtly tried to sway, monetary policy.[4]  In the footnote below, we cite Mallaby’s biography of Alan Greenspan.  This history shows that presidents not only tried to manipulate monetary policy, but Greenspan himself likely participated in a scheme to undermine Chair Arthur Burns to force him to conduct an inappropriately accommodative policy during the Nixon years.  Rubin’s argument was that Fed independence would yield a better outcome than giving the impression that politicians were guiding policy.  In other words, Fed independence would lead to lower inflation expectations and a better long-term economy.

In a CNBC interview[5] and in a “hailstorm” of tweets this morning,[6] President Trump has become increasingly critical of the Fed’s tightening policy.  Although this action is clearly a divergence from policy of the past two decades, as we note above, it isn’t at all unprecedented.  One of the hallmarks of President Trump is his desire to overturn precedent.

To some extent, we have been expecting the president to become critical of the Fed.  It is important to remember that the Fed wasn’t always “independent.”  Until 1951, the Fed acted as the funding arm of the Treasury.  That is partly how the government funded the war effort with almost no rise in interest rates; the Fed simply expanded its balance sheet, absorbing the government’s borrowing.  William Martin negotiated an “accord” with the White House and Congress in 1951 which gave the Fed independence from the Treasury.  However, there is nothing written on stone tablets that says a central bank must be independent.  In fact, central bank independence is really more a function of inflation policy.  If the goal is low inflation, central bank independence is a good idea.  If a nation wants to reflate, preventing the central bank from thwarting that goal is also appropriate.  If populism is really about reflation, reducing Fed independence is likely going to occur.  We may be seeing a move in that direction.

Bottom line: We have policies that are divergent.  On the one hand, tariffs are dollar bullish.  On the other, jawboning for a weaker dollar and threatening Fed independence could be significantly dollar bearish.  We note that any move to undermine Fed independence will also increase the risk of rising inflation expectations, which would play havoc on the bond market.  So, risks are rising.

Italy again:The populist coalition is threatening to oust Italy’s finance minister, Giovanni Tria, over Tria’s nominations for the state lending bank, CDP.  Tria is considered an establishment figure and his appointment led to stabilization of the Italian bond market.  We note that this news led the Italian 10-year rate to jump from 2.50% to 2.58%.

View the complete PDF

[1] https://www.bloomberg.com/news/articles/2018-07-20/trump-says-china-eu-have-been-manipulating-their-currencies-jjtzde52?cmpid=socialflow-twitter-business&utm_campaign=socialflow-organic&utm_source=twitter&utm_content=business&utm_medium=social

[2] https://www.cnbc.com/2018/07/19/trump-says-hes-ready-to-put-tariffs-on-all-505-billion-of-chinese-.html

[3] https://www.cnbc.com/2018/07/19/trumps-fed-criticism-is-nearly-without-precedent-in-us-history.html

[4] https://twitter.com/jimtankersley/status/1020111873923043328. Also see: Mallaby, Sebastian. (2016). The Man Who Knew: The Life and Times of Alan Greenspan. New York, NY: Penguin Books. [NB: we have reviewed this book on our Reading List]

[5] https://www.cnbc.com/2018/07/19/watch-president-trump-full-interview-with-cnbc.html

[6] https://www.cnbc.com/2018/07/20/trump-hits-the-fed-again-in-tweet-tightening-now-hurts-all-that-we-h.html