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Note: Unless otherwise specified, currency amounts described in this article are in U.S. dollars, and government references are to the U.S. government.

Is The Tariff War Turning Into A Currency War?

Key Points

  • Despite 69 rate cuts by the world’s central banks since the Fed last hiked interest rates in December, there has been relatively little currency movement by developed or emerging market currencies.

  • If rate cuts aren’t seen as enough to address slowing growth and policymakers turn to direct currency intervention, the resulting currency war could be bad news for investors.

  • In a tariff war, the U.S. has a big advantage over China due to the trade balance, but in a currency war, China has way more ammunition than the United States.

Putting an end to any hopes for a return to “normal” interest rates, central banks are increasingly cutting interest rates this year, as you can see in the chart below. 

Central banks increasingly shift to cutting interest rates

number of central banks hiking rates

*August 2019 data only through 19th of month.
Based on a study of 78 central banks.
Source: Charles Schwab. Data from Bloomberg as of 8/19/2019.    

There is likely to be much more to come. There have been 69 rate cuts by central banks since the Fed stopped hiking rates on December 19, 2018, including 12 since the Fed cut rates for the first time on July 31, as you can see in the table below.  This trend is showing no signs of slowing.

Central bank interest rate cuts since Fed stopped hiking rates

rate cut table

Based on a study of 78 central banks.
Source: Charles Schwab. Data from Bloomberg as of 8/19/2019.    

Currency war ammunition

Are these central banks on a race to weaken their currencies? In addition to stimulating growth, interest rate cuts can weaken the currency—since investors tend to seek where they can get the best real rate of interest on cash.  But rate cuts are different from direct intervention in currency markets when it comes to devaluation. Rate cuts can be matched by any country (even where rates are negative), which can offset the impact—but that isn’t always the case with direct intervention. Intervention is dependent upon resources.

In a tariff war, the U.S. has a big advantage over China due to the trade balance. But, in a currency war, China has way more ammunition than the U.S. The U.S. has the Exchange Stabilization Fund (ESF) for the purpose of intervening in currency markets. At about $94 billion in total assets, it is tiny when compared with China’s more than $3.1 trillion in non-U.S. dollar reserves. This suggests China has more than 30 times the amount of money the U.S. has to spend on currency intervention.

Big gap: China versus U.S. foreign exchange reserves

China total reserve assets

Source: Charles Schwab, U.S. Treasury, China’s State Administration of Foreign Exchange (SAFE). Data as of 8/14/2019.

Digging a little deeper, we find it’s even more unbalanced than that with the U.S. only having about $22 billion in dollar assets in the ESF that could be sold to buy yuan-denominated assets in an effort to drive down the value of the dollar versus China’s currency. This is in stark contrast to the estimate of $1.2 trillion in non-dollar reserve assets that China could use to do just the opposite—which makes the gap more than 50 times!

China has 50 times more ammunition in a currency war

China total reserve assets 2

Source: Charles Schwab, U.S. Treasury, China’s State Administration of Foreign Exchange (SAFE). Data as of 8/14/2019.

Earlier this month, the U.S. officially labelled China a “currency manipulator” which would seem to authorize direct currency intervention by the United States. However, this seems unlikely. While the U.S. has the advantage of being able to apply more tariffs on China than China can apply to the U.S., it is the opposite with currency intervention, making it less likely the U.S. would seek to turn the trade war into a currency war.

Less support

China’s currency may continue to depreciate against the dollar, barring a halt to the tariffs. That is because the Chinese currency had been stronger than market forces would indicate lately thanks to the Chinese government trying to keep the yuan from falling by fixing an exchange rate higher than market implied values in order to facilitate trade talks with the United States. But this month, China has let the yuan slide about 2%--almost all in one day, as you can see in the chart below--when trade negotiations broke down and Trump announced a new 10% tariff on $300 billion worth of imports. 

Change in value of Chinese yuan versus U.S. dollar in 2019

Yuan versus dollar

Source: Charles Schwab, Bloomberg data as of 8/15/2019.

There may be more weakness in China’s currency to come as it adjusts to market forces, since the new tariffs should have weakened China’s currency by 6% to offset the $30 billion in tariffs that are equivalent to 6% of China’s exports to the United States. But that market adjustment is different from China directly intervening to push it lower. This is a sign that China isn’t desperate and is looking to continue talks and unlikely to resort to a major devaluation.

Currency stability

While many countries are cutting interest rates, few are directly intervening to weaken their currencies. With the U.S. Federal Reserve cutting rates at the same time as other central banks, we haven’t seen a significant devaluation by major currencies against the dollar. There hasn’t been much of a move in currencies relative to the U.S. dollar despite all the rate cuts this year, as you can see in the chart below.

Little change in developed or emerging market currencies versus U.S. dollar this year

MSCI EAFE vs MSCI EM

Source: Charles Schwab, Bloomberg data as of 8/15/2019.

Emerging market currencies, measured by the MSCI Emerging Market Currency Index, have barely moved this year, dipping only one-half of a percentage point against the U.S. dollar (this includes the impact of the 2% move in China’s currency). The currencies of developed market countries that make up the MSCI EAFE Currency Index are down about one percentage point (lead lower by a 5% drop in the British pound, thanks largely to Brexit concerns). These moves are small relative to past years, suggesting a currency war doesn’t seem to be breaking out.

War: what is it good for?

If rate cuts aren’t seen as enough to address slowing growth and policymakers turn to direct currency intervention, the resulting currency war could be bad news for investors. Fighting economic weakness with a lower currency exports disinflation, reducing growth rates. While inflation erodes the value of debt over time, deflation does the opposite and the world has seen rapid debt growth in recent years. 

A devaluation would also remove an economic shock absorber that may be needed in the future. During a recession, a country’s currency usually falls, supporting a recovery. If countries seek to more directly manipulate their currencies lower now to boost growth, then it may not be an option when it’s really needed.

Might we still see a currency war? Perhaps, but it’s a zero sum game—devaluing currency to boost exports and lift inflation is at the expense of trading partners and encourages them to do the same. There could be a race to do it first, which might give policymakers a short-term crutch, allowing them to avoid having to make longer-term structural changes that could be politically costly. We will continue to monitor these developments to see if the tariff war shows signs of turning into a currency war. But, for now, it appears that a currency war remains more of a potential risk than a reality.

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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
 
All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
 
Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.
 
International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.  Investing in emerging markets may accentuate these risks.

The MSCI EAFE Currency Index tracks the performance of 21 developed-market currencies relative to the US Dollar weighted by their representation in the MSCI EAFE Index.

The MSCI EAFE Index is an equity index which captures large and mid-cap representation across 21 Developed Markets countries around the world, excluding the US and Canada. With 924 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI Emerging Markets Currency Index tracks the performance of 26 emerging-market currencies relative to the US Dollar weighted by their representation in the MSCI Emerging Markets Index.

The MSCI Emerging Markets Index captures large and mid-cap representation across 26 Emerging Markets countries. With 1,193 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.