We are all keenly aware of the trade war under way between the US and China, and several other nations, fought by the Trump Administration on a primarily unilateral basis. The main tool that the Trump Administration has employed in this effort has been an array of tit-for-tat import tariffs, gradually ratcheting up in the hopes of creating enough pain on our trading partners in the form of reduced exports into the US to induce concessions on behalf of those trading partners. To some extent, these tariffs have been effective in penalizing the targeted countries, most notably China, as evidenced by the reported growth rates in these countries. For instance, China’s Nominal GDP has slowed from around 10.0% annual growth in 2016 before the trade war commenced to approximately 6.0% today. Unfortunately, these efforts have done very little to reduce the US/China trade deficit. In fact, the US/China trade deficit has actually grown since the tariffs were implemented, largely because American manufacturers have raised their prices to match the tariffs, thereby eliminating whatever advantage was gained by the tariffs.
One particular tool in the trade war that has largely gone unnoticed but seems to be gaining attention is the use of currency devaluation, in this case the US Dollar, with the intent of making imports to US consumers more expensive.
Countries can actively work to devalue their currency relative to other global currencies. Although currency devaluation with the specific intent of creating barriers to trade is against the rules of the International Monetary Fund (IMF), it has been extremely hard to satisfy the conditions of “currency devaluation” under IMF’s rules. The main impact of currency devaluation is to make imported goods more expensive to a country’s consumers, thereby stimulating the consumption of domestically produced goods and services. Although the US has accused the Chinese government of practicing currency devaluation for years, it has never been proven conclusively and according to the rules of the IMF.
The two main tools that a government could deploy to devalue its currency are either inflation (or increasing the Money Supply) or by pressuring its interest rates lower. Effectively, by inflating the supply of its currency, the central bank would be acting to cut the global marginal demand for that currency (all else being equal). As with any commodity, when demand falls, so must the price. In this case, price is measured as the global exchange rate for that currency. Similarly, by working to cut interest rates, the central bank would be working to cut global demand for that
currency. Here again, as demand curtails, so must the price. Which again is that currency’s exchange rate relative to other global currencies.
Although the Trump Administration has been vocal about pursuing a strong dollar policy, in particular from Larry Kudlow, the actions of the Administration would suggest otherwise. Even though the Federal Reserve enjoys autonomy from political influence, they are certainly not tone deaf to the President’s tweet storms demanding lower Fed Funds rates. In fact, the Federal Reserve did cut the Fed Funds rate today (7/31/2019) for the first time in 11 years. I believe that, absent the President’s persistent badgering, Fed President Jerome Powell and the other governors would have held Fed Funds stable at 2.25% as the economy is performing well with unemployment at multi-decade lows (3.7% unemployment) and GDP growth hovering around a very stable rate of 2.1%.
If longer term interest rates, that is, those that are determined by the marketplace, such as 10-year treasury yields and 30 mortgage rates, follow the Fed Funds rates lower the US Dollar should weaken as investors seek out higher yielding assets.
Another action of the current administration that seems to be out of step with the stated strong dollar policy is the ballooning federal budget deficit. As you may have read, the proposed 2020 budget from the Trump Administration, which has yet to be approved by the Congress, breached $1T ($1,000,000,000,000.00) for the first time. A ballooning deficit will devalue the US Dollar in two ways. First, it simply expands the money supply by leveraging more government spending off the tax base. As with any commodity, if supply increases, the price of that commodity must fall. In this case, price is measured by the US Dollar exchange rate. Secondly, more and more leverage does create less investor confidence in the US’ ability to service its debt obligations. I certainly don’t mean to suggest that the US is anywhere near such a catastrophe. But, at the margin, it is a more likely possibility, which will act to reduce demand for the US Dollar at the margin.
If my observations of the empiric evidence supporting a weaker dollar policy prove to be true, my sense is that it should be a relatively limited action and more of a reset against numerous other currencies that just can’t seem to find a bottom, particularly the Euro and Yuan. However, we do need to consider possible ramifications and look for investment opportunities that should benefit from a weaker dollar.
A weak dollar will necessitate higher commodity prices as most all commodities are US Dollar denominated. It is for this reason that we have been substantially overweight Energy stocks and specifically those tied to Oil & Gas production. Although this strategy has been a substantial drag on our investment performance for several quarters as West Texas Intermediate Crude (WTI) prices continue to fall, we continue to remain overweight. We continue to believe that higher WTI prices are coming in the relatively near future as the Trump Administration’s trade war wages on. In fact, today’s Fed Funds rate cut may be just the stimulus needed to spur on global economic activity, which will necessitate more crude oil consumption.
Another ramification of a weak dollar policy on our investment philosophy will be to continue to hold relatively short-term maturities on the fixed income (bond) holdings we manage. This may seem a little counterintuitive as locking in higher interest rates today before rates are pressured lower would seem to be a smart decision. However, I am concerned that investors are becoming more aware of the Administration’s unspoken weaker dollar policy and will curtail their purchases of US treasuries, thereby forcing market determined interest rates higher.
Clearly, if my assessment is correct and the US has tacitly adopted a weaker dollar policy, the rules we all take for granted around the US Dollar will also change. We are working hard to consider further ramifications of this possibility and will certainly implement those conclusions into our management of your account(s) with us.
As always, please feel free to contact us if you have any questions or if you need to schedule an appointment to discuss your account or financial plan with us. This is particularly important if you have experienced a big change in your life recently (got married, retired, changed employment, bought/sold a business, etc.).
2018 Form ADV Notice and Offering – the firm’s 2018 amended Form ADV Part 1 & Part 2 filings with the Securities Exchange Commission was filed timely 02/21/2019. If you would like a copy of this important disclosure document, please contact us at (303) 442-3670 or firstname.lastname@example.org and we will be happy to deliver it to you at no charge.
Mark P. Culver
Culver Investment Company, LLC
360 Interlocken Blvd
Broomfield, CO 80021
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