By Seema Shah, Chief Strategist, Principal Global Investors
The Federal Reserve's (Fed) decision to cut policy rates by just 25 basis points meets market expectations. But it's perhaps a bit of an anti-climax compared to last week's European Central Bank (ECB) meeting where Mario Draghi set the stage for a comprehensive easing package. Equities haven't responded to the Fed's action too positively, but it's the currency market, via a stronger U.S. dollar, where much of the disappointment will be played out. And, in turn, in the White House Oval Office.
Going by President Donald Trump's tweeted accusations of currency manipulation in response to Draghi's dovish speech at Sintra last month, today's relatively underwhelming Fed action will test his patience. I fear another tweetstorm is brewing.
But is he onto something? At first look, no. What President Trump sees as unfair competitive devaluation is simply how monetary policy works. What's more, with over 40% of global bonds outside the U.S. trading at negative yields, U.S. 10-year Treasury at just 2% are actually high yielders. The U.S. can't help but attract capital.
On closer inspection, however, I think Trump may be onto something.
Consider that ECB deposit rates are in negative territory, weighing on bank lending margins, so further cuts only undermine its efforts at stimulus. Quantitative easing will certainly help, especially through corporate bond purchases. But with much of the universe already yielding negative rates, even this tool is running low on fuel.
And so, with interest rates very low and fiscal policy constrained by politics, a weaker euro has become one of the very few ways the ECB can support the economy. In other words, perhaps ECB policy is aimed at pushing the euro lower.
Essentially, when central banks turned to unconventional monetary policies a decade ago, driving interest rates to record lows, they progressively rendered the traditional monetary policy toolkit ineffective, leaving central banks with little choice but to resort to covert currency wars. This is the logical next chapter to follow quantitative easing.
If the Fed continues to under-deliver relative to the ECB, a stronger dollar will ensue. President Trump seems all too aware of this new phase of central bank policymaking, leaving the Fed with a difficult prospect over the coming months: either follow the ECB in loosening monetary policy aggressively... or the U.S. government may weaken the dollar itself.
Active currency intervention would be via the White House instructing the Treasury to sell dollars to drive the greenback's price down. But, it would only be successful in the short term. After all, unilateral intervention would surely prompt retaliatory action from other central banks, triggering a so-called race to the bottom.
Today's Fed meeting may have thrown cold water on prospects for further easing, spurring a firmer dollar and associated emerging market stress in the short term. However, ECB monetary easing next month should quickly re-dress the Fed's relatively hawkish bias, putting it under pressure to cut rates further.
The net beneficiary of a covert currency war between the U.S. and Europe will ultimately be emerging market assets. If Europe and the U.S. compete to lower the value of their currencies, emerging markets and Asian countries, which tend to borrow in dollars, will benefit in the longer term.
Keep in mind too that, at some point, the Trump administration may realise that a more effective and beneficial route to weakening the U.S. dollar will be to correct the underlying fundamentals - the most pressing issue of which is the trade war. U.S. tariffs are weakening target economies, putting downward pressure on their currencies and upward pressure on the U.S. dollar. If President Trump wants a cheaper dollar, ending the trade war may be his best bet.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.