Welcome to Thoughts on the Market.
I'm James Lord, Global Head of FX and EM Strategy at Morgan Stanley.
And I'm Seth Carpenter, Morgan Stanley's Global Chief Economist and Head of Macro Research.
Today we're talking about US currency policy and whether recent news on intervention and nominations to the Fed change anything for the outlook of the dollar.
It's Thursday, February 19th at 3pm in London.
So it's been an interesting few weeks in currency markets, plenty of dollar selling going on.
But then we got news that Kevin Walsh is going to be nominated to chair of the Board of Governors.
And that sent the dollar back higher, reminding everybody that monetary policy and central bank policy still matter.
So, in the aftermath of the dollar-yen rate check, investors started to discuss whether or not the US might be starting to target a weaker currency currency not just be comfortable with a weaker currency, but actually explicitly target a weaker currency, which would presumably be a shift away from the strong dollar policy that Secretary Besant referenced.
So what is your understanding?
What do you think the strong dollar policy actually means?
Strong dollar policy.
That's a phrase, that's a term, it's a concept that lots of secretaries of the Treasury have used for a long time.
And I specifically point to the Secretary of the Treasury, because at least in the recent couple of decades, there has been, in standard Washington DC approach to things, a strong dichotomy that currency policy is the policy of the Treasury Department, not of the central bank.
And that's always been important.
I remember when I was working at the Treasury Department that was still part of the talking points that the secretary used.
However, you also hear secretaries of the Treasury say that exchange rates should be market determined, that that's a key part of it.
And with the back and forth between the US and China, for example, there was a lot of discussion.
Was the Chinese government adjusting or manipulating the value of their currency?
And there was a push that currencies should be market determined.
And so if you think about those two things at the same time, pushing really hard that the dollar should be strong, pushing really hard that currencies should be market determined, you start to very quickly run into a bit of an intellectual tension.
And I think all of that is pretty intentional.
What does it mean?
It means that there's no single clear definition of strong dollar policy.
It's a little bit of the eye of the beholder.
It's an acknowledgement that the dollar plays a clear key role in global markets, and it's good for the US for that to happen.
That's traditionally been what it means, but it has not meant a specific number relative to any other currency or any basket of currency.
It has not meant a specific value based on some sort of long run theoretical fair value.
It is always meant to be a very vague, deliberately so, very vague concept.
So in that version of what strong dollar policy means, presumably the sort of ambiguity still leaves space for the treasury to conduct some kind of intervention in dollar yen if they wanted to.
And that would still be very much consistent with that definition of the strong dollar policy.
I also, in the back of my head, always wonder whether the strong dollar policy has anything to do with the dollar's global role.
And the sort of foreign policy power that that gives the Treasury in sanctions policy, in other areas where they can control dollar flows and so on, and that gives the US government some leverage.
It allows them to project strength in foreign policy.
Is that anything to do with the traditional versions of the strong policy?
Absolutely.
I think all of that is part and parcel to it, but it also helps to explain a little bit of why there's never going to be a very crisp, specific numerical definition of what a strong dollar policy is.
So, first and foremost, I think the discussion of intervention, I think it is in lots of ways consistent, especially if you have that more expansive definition of strong dollar, ie the currency that's very important, or most important, in global financial markets and in global trade.
So I think in that regard you could have both the intervention and a strong dollar at the same time.
I will add though, that the administration has not had a clear, consistent view in this regard in the following very specific sense
When now Governor Mirren was chair of the Council of Economic Advisors, he penned a piece on the Council of Economics website that said that the reserve currency status of the dollar had brought with it some adverse effects on the US in terms of what happened in terms of trade flows and that sort of things.
So again, this administration is also concerned tried to find ways to increase the nuance about what the currency policy is and putting forward the idea that too strong of a dollar in the FX sense, in the sense that you and your colleagues in FX markets would think about is high valuation of the dollar relative to other currencies could have contributed to these trade deficits that they're trying to push back against.
So I would say we went from the previous broad, perhaps vague, definition of strong dollar and now we're in an even murkier regime where there could be other motivations for changing the value of the dollar.
So James, that's been our view in terms of the Fed.
But let me come back to you because there are lots of different forces going on at the same time.
The central bank is clearly an important one, but it's only one factor among many.
So, if you think about where the dollar is likely to go over the next three months, over the next six months, maybe over the next year, what is it that you and your team are looking for?
Where are the questions that you're getting from clients?
Yeah, so when we came into the start of this year, we did have a bearish view on the dollar.
I would say that the drivers of it, we split up into two components.
The first component was a lot more of the conventional stuff about growth expectations, what we see the Fed doing.
And then there was another component to it where what we define as risk premia I suppose the more unconventional catalysts that can push the dollar around as we sort of come very much to market attention during the second quarter of last year, when the Liberation Day tariffs were announced and the dollar weakened far in excess of what rate differentials would imply.
And so I would say, so far this year, the majority of the dollar move that we've seen, the weakening in the dollar that we've seen, has been driven by that second component, what we kind of call risk premia.
And the conversations that investors have been having about US policy towards Greenland, and then, more recently, the conversations that people have been having around FX intervention following the dollar-yen rate check.
These sorts of things have been really driving the currency up until when the Kevin Walsh nomination was announced.
When we look at the extent of the risk premium that we see in the dollar now, it is quite pretty close to the levels that we saw in the second quarter of last year, which is to say it's pretty big.
Eurodollar would probably be closer to 110 if we were just thinking about the impact of rate differentials and none of this risk premium stuff over the past year had materialized.
That's obviously a very big gap and I think for now that gap probably isn't going to widen much further, particularly now that market attention is much more focused on the impact that Kevin Walsh will have on markets and the dollar.
We also have the ECB and the Bank of England.
House call for those two central banks is for them to be cutting rates.
That could also put some downward pressure on those currencies. relative to the dollar.
So all of that is to say, for some of the major currencies within the G10 space, like sterling, like euro against the dollar, this probably isn't the time to be pushing a weaker dollar.
But I think there are some other currencies which still have some opportunity in the short term, but also over a longer run as well.
And that's really in emerging markets.
So all of that is to say I think there is a strong monetary policy anchor for emerging market currencies.
This is an asset class that has been underinvested in for some time.
And we do think that there are more gains there in the short term and over the medium term as well.
So on that topic, James, would you then agree?
So if I think about some of the EM central banks, think about Banxico, think about the BCB, where the dollar falling in value, their currency gaining in value, that could actually have a couple things go on to allow the central bank maybe to ease more than they would have otherwise.
One, in terms of imported inflation, their currency strengthening on a with a bit lower inflation.
And secondly, a lot of EM central banks have to worry a bit about defending their currency, especially in a volatile geopolitical time.
And you were pointing to sort of lower volatility more broadly.
So is this sort of a reinforcing trend perhaps where, if the dollar's coming down a little bit, especially against EM currencies, it allows more external stability for the central banks, allowing them to just focus on their domestic mandates, which could also lead to a further reduction in their domestic rates, which might be good for investors?
Yeah, I think there's something to that.
Given the strength of emerging market currencies, there should be, over time, more space for them to ease if the domestic conditions warrant it.
But so far, we're not really seeing many EM central banks taking advantage of that opportunity.
There is a sort of general pattern with a lot of EMs that they're staying pretty conservative and more hawkish than I think what markets have generally been expecting.
And that's been supporting their currencies.
I think it's interesting to think about what would happen if they're on the flip side.
What would happen if they did start to push monetary easing at a faster pace?
I'm sure on the days where that happens, the currencies would weaken a little bit.
However, if the market backdrop is generally constructive on risk and investors want to have exposure to EM, then what could ultimately happen is that asset managers will simply buy more bonds as they price in a lower path for central bank policy over time, and that causes more capital inflows.
And that sort of overwhelms, the knee-jerk effect from the more dovish stance of monetary policy on the currency.
You get sort of more duration flows coming into the market, and that helps their currency.
And yes, if EM central banks push back with more dovish policy significantly, it could pose some short-term volatility.
But assuming we remain in a low vol environment globally, I would use those as buying opportunities.
Thanks, James.
It's been great being on the show with you.
Thank you for inviting me.
And I hope to be able to come back and join you at some point in the future if you'll have me.
Thank you, Seth, for making the time to talk.
And to all you listening, thank you for lending us your ears.
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