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The Davos Divorce

When US Treasury Secretary Steven Mnuchin dared touch what was a third rail for a Treasury Secretary – talking down the US dollar – he had done something not done since 1992 when Secretary Lloyd Bensten engaged in a full-blown currency war. While former Treasury Secretary Larry Summers was quick to rip into fresh meat, saying a “vicious cycle can result” if a currency war results, it was Deutsche Bank’s Alan Ruskin who proclaimed January 24th as the day in currency folklore that should be historically referred to as “The Davos Divorce.”

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Dropping the currency value might help economically in the long run, but...

The term “currency war” evokes a wonderfully provocative image of staid and elite economic confabs suddenly getting emotional over their economic fortunes as they toss epithets at their currency in a race to the bottom.

The dropping value of a currency often occurs when a national economy is faltering. It can have the impact of increasing foreign investments, as the foreign currency goes further. The technique is often viewed as positive for local manufacturing, as it makes their exports less expensive. But for imports it often generates higher costs – and can result in inflation.

But for Ruskin the issue is nuanced.

A currency war “often feels inappropriate and filled with hyperbole, unless it is applied to the biggest players: US v China, or now US v Europe,” he wrote in a January 25 report.

And this hyperbole, while it might feel could in the here and now, but the benefits won’t last.

“While the US could win in the short term…  let’s have no doubt about the outcome,” he wrote. “We expect US to win the battle, and lose the war.”

Historically US administrations follow a strong dollar policy

Historically the US has publicly talked up its currency – known as a strong dollar policy – while it derided countries that manipulated their currency lower to obtain an economic benefit.

But now with the US talking down their currency, Ruskin has no doubt the markets will let them do it, but it is sending a challenging message.

“The US can weaken its currency,” Ruskin tempts, pointing to the club that will hit the nation over the head if it proceeds. “The US should however be very attentive to the contradiction in the message that says ‘foreign capital welcome’ and in the same breath ‘welcome a weaker dollar.’"

You can’t eat your cake and have it too.

There are risks to talking down the currency, but Ruskin looks at the larger issue. Why take the risk when the economy really doesn’t need it?

He think’s Mnuchin should “beat a hasty retreat from currency manipulation” because “the US economy really does not need this extra FX boost to add to the fiscal stimulus.”

Not only does talking down the dollar risk the economy overheating “even though the Fed will almost certainly counteract the reflationary impulse.” There are also political ramifications that are less about economics and more about politics, Ruskin observes.

“What is at risk is the US's authority in esteemed institutions and global forums, most obviously when encouraging more flexible currency regimes and arguing against currency manipulation,” he wrote, pointing to a loss of the moral high ground:

One ready made retort to a US accusation of manipulation is to explain they are only intervening (buying USD) as their way of offsetting US verbal intervention! “America First” applied to currencies, can either be a rush to the bottom for all currencies in classic beggar thy neighbor world; or, in more benign fashion encourage intervention by large open economies to avoid their currencies appreciating. What is at certainly stake here is the G20 world order to avert currency manipulation across the developed and developing world.

The path is not set in stone if Mnuchin recognizes the error of his ways:

Fortunately reconciliation in global currency politics is still possible. For that to quickly happen the US administration must recognize that while a weaker USD may look like "a free lunch", with all the gains on growth/exports, and only a little pain on inflation, it is not free when placed in the wider global context. The alternative is that the US relinquishes leadership on currency politics to other countries - a splintering of power that will certainly help China. In the meantime, the currency squabbling harks back to an era where macro funds could chase government intervention and Central Bank distortions for considerable gain. Certainly it is a boon for vol, and not just currency vol. For there is also another big lesson for a US Administration that has shown particular sensitivity to equity valuations. The last most vocal G2 squabble between Europe and the US related to currencies was when Germany’s Stoltenberg and James Baker locked horns. It was perhaps the most important global macro trigger that brought an ebullient stock market back to earth with a thud back in October 1987.

With the economy picking up steam at a time the Trump administration is under pressure domestically, pumping the economic gas pedal and delivering on other key campaign promises might be just what the doctor ordered in the short term, but there are longer term consequences, Ruskin observes.