Thoughts on Conspiracy Theories of the Dollar’s Losses

In our work, we have argued that the dollar is having its third significant rally since the end of Bretton Woods.   The first rally was associated with Reagan though it began under Carter and followed 100 bp hike by a new Federal Reserve Chairman (Volcker).

Before last month's G20 meeting, some had talked about the possibility of another Plaza-like agreement.  We downplayed such suggestions.  There was no appetite for intervention.  Many countries are still easing monetary policy, and typically central banks want their currencies to move in the same direction as monetary policy.  Otherwise, the foreign exchange market would dilute the impact of the easier policy.

We also argued that ideologically, the US and Europe could not press China (and others) to allow market mechanisms to drive foreign exchange prices, and then intervene when they did like what the markets had done.   With the notable exception of the intervention after the Japan's tsunami and nuclear accident, there was not G7 intervention in the foreign exchange market in recent years.  Even during the 2008-2009 Global Financial Crisis (GFC), the G7 did not intervene.  Swap lines between central banks provided access to the needed dollar funding.

In addition, the dollar's strength is generally understood to be part of the solution, not the problem.  The US responded relatively early and aggressively to the GFC.  It asset purchases began in 2009.  The ECB and BOJ begin their programs several years later, for example.  A weaker euro and weaker yen are part of the solution not part of the problem.

Nevertheless, some observers are arguing that there was a secret G20 agreement to stop the dollar from rising.    Leave aside the fact that euro made its low a year ago (16 March 2015) near $1.0460.   Leave aside the fact that the dollar fell almost 9% against the yen in the two weeks prior to the G20 meeting.  Leave aside the fact that G20 officials have repeatedly denied such conspiracy theories.

The secret agreement was to "roughly stabilize the dollar versus the major currencies through appropriate monetary policy action, not through intervention."     However, consider what has happened since the G20 meeting.  The PBOC cut reserve requirements.  The ECB not only cut rates deeper into negative territory but accelerated and broadened its asset purchases.  The Bank of Japan cut rates into negative territory for the first time before the G20 meeting.  Although it left rates on hold this week, the BOJ is expected to ease policy further as early as next month.  Norway cut interest rates and warned that negative rates should not be ruled out.  New Zealand also cut interest rates and indicated lower rates may still be needed.

It is true that the Fed scaled back the four rate hikes it had anticipated in December for 2016.  However, the market never had discounted that scenario.  As US economic data strengthened in recent weeks, and the fear of recession subsided, and energy prices rose, the pendulum of expectations swung back from not pricing in a single hike to pricing in nearly two.   Between the G20 meeting and this week's FOMC meeting, the market priced in an increased likelihood of a June rate hike.

What about the yuan?  The dollar peaked, at least thus far, on 8 January near CNY6.5960.  Chinese officials, long before the G20 meeting, took steps to stabilize the yuan.  The PBOC fixed the yuan 0.5% higher today, the most since November.  The dollar was at its lowest level since the second half of last December today.  For the record, more of the yuan gains took place before the G20 meeting than afterward.  Also, Chinese officials have repeatedly said they do not seek a large devaluation.  They reiterated its stance at the G20 meeting.

The focus on intervention this week has been in Japan.  The sharp recovery of the dollar after spiking down to nearly JPY110.65 yesterday sparked talk of BOJ intervention.  We are skeptical.  First, given the criticism of Japan at the G20 meeting and the fact that there has not been G7 intervention, the bar to BOJ action is very high.  Second, intervention outside of Tokyo is diplomatically more complicated.  Our understanding is that it is customary for a central bank to request permission to intervene in another central bank's markets.  Formally, this would have required Federal Reserve, and likely the US Treasury (where the onus of dollar policy resides).

Third,  if the BOJ would have actually intervened there would be not doubt of its presence.   Someone would confirm having transacted with it.  Fourth, since the FOMC meeting, it has not been a yen move, but a dollar move.  This too would have dissuaded the BOJ for intervening.  Fifth, unilateral BOJ intervention has a poor track record of success.  Coordinated intervention has a somewhat better track record.

We suspect that rather than celebrating the success of the secret Plaza-like Agreement, officials are just as surprised and discombobulated as investors by the market action.  In our conversations with various officials, we do not get the sense that the rise of the yen, euro, and dollar-bloc currencies is wholly desired.  To the extent that many countries are wrestling with deflation or lowflation, the rise in commodity prices, the more than 40% rise in oil prices since mid-January (a month before the G20 meeting), may be welcomed.

The Reagan dollar rally was driven by the policy mix.  Reagan had his foot on the fiscal accelerator.  Volcker had his foot on the monetary brake.  This policy mix is the best for a currency.  It is the same policy mix (and roughly of the same magnitude of GDP)  as German's policy mix after the Berlin Wall fell, leading to the uber-mark overshoot of the early 1990s).  The Obama dollar rally is driven by the divergence of monetary policy.

Despite the dovish read of the FOMC, the fact of the matter is that it anticipates two hikes this year still.  This is hardly dovish though it is less hawkish.    The ECB's large policy measures earlier essentially take them out of the picture for Q2, and probably Q3 as well.  The impact of the current measures needs to be studied.  The rise of commodity prices buys some time too.  Nevertheless, the ECB is still easing policy.  The BOJ may ease again in Q2, and its asset purchase program continues unabated.

Monetary divergence has not peaked, and although there is not a one-to-one correspondence with the foreign exchange market, which has other influences and subject to contradictory impulses, over time it is likely to underpin the dollar.  Provided the rise is orderly, which means occasional setbacks, the dollar's rise is unlikely to spur an international agreement, secret or otherwise.

Lastly, we have noted the temporal inconsistencies of central bankers; we recognize the same in the market.  The Fed funds futures market has swung from no chance of a single hike this year in the US to increased chances of two (before the FOMC meeting).  The market has swung from the US is likely headed for a recession to slow but trend-like growth is set to continue.  We have argued against the currency war and race-to-the-bottom narrative that was popular in the press.  Now many are swinging hard in the opposite direction.  There is a secret agreement to prop up the other major currencies and depress the dollar.  Be skeptical.