The Fed is working against the Whitehouse
While the White House and Fed may be united in their desire to see a weaker US dollar and more inflation, the Fed is doing nothing to achieve that.
The Fed has been on a path of raising interest rates for almost three years, beginning with the ‘lift-off’ rate hike in December 2015.
Since October 2017, the Fed has also been tightening money supply by not reinvesting in US Treasury securities when existing securities in their portfolio mature.
This ‘quantitative tightening,’ or QT, is the opposite of quantitative easing, QE.
The combination of rate hikes and QT has caused a significant increase in US interest rates in all maturities and, in turn, a stronger US dollar as capital flows to the US in search of higher yields.
The result is a persistently strong US dollar.
This means that if the White House and US Treasury want a weaker US dollar, they may have to achieve it on their own with no help from the Fed.
The US Treasury is well-equipped to do this kind of intervention by using their Exchange Stabilisation Fund, or ESF.
The ESF was created under the Gold Reserve Act of 1934, which provided legal ratification for FDR’s confiscation of private gold from US citizens in 1933. FDR paid US$20.67 in paper money for the gold in 1933, knowing he intended to raise the price of gold.
His plan was to capture the ‘gold profits’ for the government instead of allowing citizens to realise the profits. Those profits were the original source of funding for the ESF.
Dipping into the money bucket
Importantly, the ESF exists completely outside of congressional control or oversight. It is tantamount to a US Treasury slush fund that the US Treasury can use as it sees fit to intervene in foreign exchange markets.
No legislation or congressional appropriation is required.
Former US Treasury Secretary Bob Rubin used the ESF to bail out Mexico in 1994 after Congress had refused to provide bailout money through other channels.
Today, the ESF has net assets of about US$40 billion.
The gross assets include about US$50 billion in SDRs, but the US Treasury can issue SDR certificates to the Fed in exchange for dollars if needed to conduct currency market operations.
The biggest offender in the currency wars today is China, which has devalued the yuan 10% in the past six months to offset the impact of higher tariffs imposed by Trump.
China’s cheap-yuan policy is undermining Trump’s trade war policies.
After biding their time, Trump and Mnuchin are ready to lower the boom on China with a cheap-dollar policy after the US midterm elections. Of course, China will not be alone in feeling the impact of the new, cheap dollar. Europe and the euro are also in the line of fire.
With this background in mind, what is the outlook for US dollar exchange rates?
The single most important factor in the analysis is that two currencies cannot devalue against each other at the same time.