It is rare for Wall Street analysts to break the echo chamber of the intellectual Trump #resistance – after all, “Orange man crazy, his tweets make no sense” remains all the rage among those who are paid 7 figures for their (mostly wrong) economic insight; it wouldn’t look good if Trump, breaking through the barriers of political correctness and obfuscation, exposes “deep” economic and financial truths on twitter. For free.
One person who has no fear in defying Wall Street convention is also one of its biggest perma-bears (which it comes to equities, and the opposite for bonds), SocGen’s Albert Edwards, who in his latest letter brings attention to the barrage of recent tweets from President Trump indicating that “his tolerance for the strong dollar has just about run out.”
As we observed roughly two weeks ago, the dollar had resumed its rise even ahead of the stellar payrolls report, largely due to the prospect of yet another round of Draghi “whatever it takes” jawboning and even easier ECB policy – sending eurozone bond yields to record lows.
So as the global economy falls ever closer towards outright deflation, Edwards predicts that “the global currency war will explode into life. Countries will fight to avoid deflation in the next recession and competitive devaluation will be the tool of choice.” Indeed this was the solution Ben Bernanke suggested in his famous 2002 speech about how to avoid ending up like Japan, to wit:
“Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today (ie 2002), it’s worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US history is Franklin Roosevelt’s 40% devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 % in 1932 to -5.1% in 1933 to +3.4% in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation.”
While Edwards is hardly the first analyst to suggest that the US will intervene directly in devaluing the dollar – BofA did so three weeks ago – the SocGen strategist is certainly the one to present the most comprehensive case why what may be the final lap in the race to the currency bottom has just begun.
Specifically, Edwards begins by pointing out that while the primary target of Trump’s trade war ire has conventionally been China, he should be focusing on Japan, and perhaps even more so, Europe – and Germany in particular. As the SocGen strategist writes, “it would not have missed President Trumps attention that while the US recorded an overall $625bn trade deficit in 2018, the eurozone ran a huge $600bn surplus (over 4% of GDP). By contrast China and Japan ran surpluses of only $100bn and a $10bn respectively.”
In other words, “when it comes to global trade imbalances China and Japan are not the problem” – according to Edwards, it’s the Eurozone.
Which is not to say that Trump has missed what Europe is doing; quite the contrary, and he is getting rather angry with the ECB: “They have been getting away with this for years, along with China and others, Trump said in a tweet, noting a weaker euro would make it unfairly easier for them to compete against the USA.”
In this context, Trump’s response to any further ECB easing will likely “cause an explosion of anger.” And, as Edwards controversially adds, “you know what? I think Trump has a good point.”
Of course, Trump was reacting to the weakening of the euro in response to ECB President Mario Draghi trialling yet more monetary easing. In response to Trumps tweet, Draghi pushed back on the idea that the ECB was deliberately weakening the exchange rate. He told the audience at the ECBs annual forum in Sintra, Portugal, “We have our remit, we have our mandate. Our mandate is price stability defined as a rate of inflation which is close to, but below, 2% over the medium term.” He also reiterated that the eurozones central bank is “ready to use all the instruments that are necessary to fulfill this mandate. And we don’t target the exchange rate,” he said to applause from the crowd.
The applause was short-lived however, and may soon turn to tears, and not just in Europe but Japan too: as Edwards explains further, “there is no doubt that the dollar is overvalued, not just against the euro but against a basket of currencies. But so too is the Chinese renminbi (although the gap versus the US has narrowed as the Chinese have allowed the bilateral rate to slide towards $7.0/Rmb). But if you really want to see a major currency that is cheap, it is the yen and not the euro that stands out as anomalously undervalued (see chart below).”
So why, Edwards asks, is it the euro’s weakness that is particularly irritating to President Trump at the moment? Well for one thing, while China’s formerly giant current account surplus has almost disappeared, collapsing from $300BN in 2015, it is now expected to be a deficit of $20BN this year, while Japan is expected to post a $30BN deficit, it is the Eurozone which collectively will post a massive $600BN surplus.
When we talk about the burgeoning eurozone external surplus, we all really know that is shorthand for Germany – and so does President Trump. Germanys overall current account surplus dominates the eurozone surplus and has been topping a massive 8% of its own GDP recently (although projected by the OECD to decline to 7.3% GDP this year). To be sure other European countries run bigger surpluses the Netherlands and Switzerland at 11% and 10% of their own GDP respectively. But these are small countries, and nobody really cares about them in terms of global macro imbalances. They do care about Germany though.
Additionally, with an external imbalance recently topping 8% of GDP, “Germany now runs the biggest single dollar trade and current account surplus in the world.” But Germanys external macro imbalance has been unusually large since around 2004. What has changed? Why is it only in recent years that it has been attracting such aggressive attention and not just from the current Trump Administration, but within the EU itself? (As Edwards reminds us, the EC previously launched investigations into the macro damage Germany’s external imbalance is causing.)
The answer is that for many years, Germany’s gargantuan external surplus was more or less given a pass up until the eurozone crisis of 2011. That, as Edwards notes, was because the eurozone periphery was the mirror image of Germanys huge current account surplus (see chart below). Inappropriately loose monetary policy was foisted on the periphery by the one-size-fits-all monetary policy and resulted in credit bubbles in those economies. The periphery borrowed heavily from an obliging Germany who recycled their domestic savings surplus into the hands of domestic periphery consumers. The periphery acted as a sponge, soaking up German excess saving – and the overall eurozone, by and large, remained broadly in external balance with the rest of the world. Germany’s huge surplus was nobodys concern but the eurozones.
That has now changed, and the problem for the rest of the world now is that under stringent post-eurozone crisis austerity, the eurozone periphery sponge has been totally squeezed out and the rest of the world is being now forced to soak up excess German saving (ie the mirror image of the current account surplus). The eurozone periphery could even be thought of as a giant economic plaster, previously covering up a wound. That plaster has now been ripped off and wound is now flowing copiously and drowning the rest of the world in surplus savings.
So what happens next?
Since there are no new economic laws under the sun, the solution to this problem from the point of view of correcting the eurozone external imbalance is a substantially looser fiscal policy and a somewhat tighter monetary policy.
But as SocGen correctly points out, “while fiscal hawks still dominate thinking within the eurozone, nothing can change.” To be sure the appointment of Christine Lagarde as the new ECB President may mark a shift in thinking, but Edwards just cannot see a European Commission (EC) abandoning its dogma. Indeed, the ECs recent run-in with Italy demonstrates its ideological inflexibility.
* * *
So what does all of that have to do with the global currency war?
Simple: according to Edwards, the problem going forward is “it won’t just be Japan and the eurozone that will be trying to devalue their way far from the deflation quagmire, but also the US.” Specifically, US authorities under the lead of President Trump will embrace Ben Bernanke’s 2002 advice of a competitive devaluation similar to that seen in 1933/4 like a long-lost friend (perhaps Trump will seek to reappoint Bernanke if he needs a Fed chairman for the final round of currency debasement).
At this point, Edwards conducts a thought experiment:
Let us imagine for a moment that the US slides into outright recession before the end of 2020 as most commentators believe. We have highlighted previously how underlying consumer price inflation is running considerably below the 2% suggested by the core CPI or the 1.6% of the core PCE deflator (core defined here as ex food and energy). We monitor closely the US core CPI excluding the bulk of the shelter component (ie excluding owner equivalent rent but not actual rent). This puts the US core CPI on the same basis as the eurozone core CPI. Both series are running between 1-1½% currently, but the US measure is decelerating sharply (see lefthand chart below). Similarly the Feds preferred target measure of consumer price inflation, namely the core PCE deflator (Personal Consumption Expenditure) is also decelerating sharply if one looks only at items that can be explicitly measured (rather than estimated) in the market-based core PCE measure.
Another side effect of conventional economics – and a strong dollar – is that US non-petroleum import prices are declining again, which as both Edwards, we we several weeks ago, pointed out, “the US is importing other countries deflation. Not cool.“
Which then brings us back to Edwards’ favorite talking point: predicting near-term gloom, and sure enough…
A US recession and outright deflation could be closer than many suppose. The recent slide in US ISM manufacturing new orders relative to inventories warns us of a sharp and imminent GDP slowdown as does the recent weakness in Gross Domestic Income. The NY Fed Nowcast stands at only 1.5% for Q2 and 1.7% for Q3. The US economy is at stall speed and may even already be sliding into recession and outright deflation.
Which then brings us to the US “reaction function”, and Edwards’ belief that “the US will soon be forced by events to join the eurozone and Japan in aggressively fighting deflation. I expect that in addition to President Trump using auto tariffs as a weapon in the intensifying currency war against the eurozone (Germany), he will instruct the US Treasury (via the NY Fed) to intervene directly and unilaterally to drive the dollar lower – much lower.”
Just as Bank of America predicted several weeks ago.
In fact, Edwards writes that he is surprised the US “has not done so already, but any additional ECB easing will surely be the straw that will break the camels back. And unlike in the eurozone, it is absolutely clear and unambiguous in the US who has the call on FX intervention: it is the Administration and not the Washington Federal Reserve.”
But wait, there’s more, because in addition to the US directly intervening in FX markets, one last policy tool that SocGen believes will be weaponized is negative Fed Funds:
With both the ECB and BoJ key policy rates already negative, it would be madness for the US Administration not to fight the global currency war on this battlefield in addition to all the others.
Wait, isn’t it against the Fed’s mandate to pursue negative rates? Yes… but when has that stopped a central bank (see the ECB). As Edwards counters, one of the main arguments heard against the Fed taking Fed Funds deeplynegative is the damaging impact it would have on banking sector margins. Certainly in both the eurozone and in Japan there was a huge initial backlash for bank stocks as negative interest rates were announced. But then, as the SocGen strategist adds, after a recovery in the sector on hopes that the central banks would not pursue this policy further, “the slide has resumed as growth has floundered and the prospect of even more negative rates becomes a scary reality.”
That said, this time will be different, and Edwards’ answer to concerns about the damage negative Fed Funds would have on US bank margins is that “this is 2019, not 2007/8. Although the investment community has not anticipated the depth of the next global recession and equity market collapse, I do not expect banks to be the centre of the unfolding crisis which will likely be focused on holders of US corporate paper, especially investment grade, and equities.”
We are told that unlike 2007, neither investment nor commercial banks warehouse inventory of these instruments. There will no doubt be much money to be lost by the banks in the souring of leveraged loans, ordinary commercial loans and property loans, but I do not believe that banks will be the apex of the next crisis as they were in 2007/8. Hence they will not be the priority for policymakers.
For once a dose of optimism from Edwards? Well, perhaps not, as he next proposes that “banks in the US could soon be looking a lot more like those in Europe.” Instead, a far bigger priority in the next global economic downturn will be US policymakers fighting deflation rather than maintaining US bank profitability:
one of the lessons of Japan in the 1990s and the eurozone more recently is that it is economic stagnation and outright deflation that leads to problems in the banking sector, and not the other way around. And yes, the utilisation of negative interest rates is definitely not good news for banks, but it is better than allowing outright deflation to unfold with negative trend nominal GDP, corporate profits and household income growth wreaking havoc on bank balance sheets as over-leveraged borrowers see their real debt loads explode.
To confirm that point, Socgen points out that “Japanese banks did not start underperforming the overall equity market until well into the lost decade of the 1990s, and only after Japan had actually
tipped into outright deflation”. Indeed, Japanese banks were not the problem: “they were a symptom of the problem, which was the economy slipping into outright deflation.”
Finally, Edwards reminds Japan watchers that the catalyst that tipped the country into outright deflation in the 1990s was a persistently strong yen, and he goes on to point out that “President Trump is not about to make that same mistake. Personally, I am surprised he has put up with the ECB winning the competitive devaluation game for so long. Expect the dollar to fall – bigly.”
His gloomy – what else – conclusion: “The ECB have just fired the starting gun. This will turn nasty.“
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