Our Global Head of FX and EM Strategy James Lord and Global Chief
Economist Seth Carpenter discuss what’s driving the U.S. policy
for the dollar and the outlook for other global currencies.
Read more insights from Morgan Stanley.
----- Transcript -----
James Lord: Welcome to Thoughts on the
Market. I’m James Lord, Global Head of FX and EM Strategy at
Morgan Stanley.
Seth Carpenter: And I'm Seth Carpenter,
Morgan Stanley's Global Chief Economist and Head of Macro
Research.
James Lord: Today we're talking about U.S.
currency policy and whether recent news on intervention and
nominations to the Fed change anything for the outlook of the
dollar.
It's Thursday, February 19th at 3pm in London.
So it's been an interesting few weeks in currency markets. Plenty
of dollar selling going on But then, we got news
that Kevin Warsh is going to be nominated to Chair of
the Board of Governors. And that sent the dollar back higher,
reminding everybody that monetary policy and central bank policy
still matter.
So, in the aftermath of the dollar-yen rate check, investors
started to discuss whether or not the U.S. might be starting to
target a weaker currency. Not just be comfortable with a weaker
currency, but actually explicitly target a weaker currency, which
would presumably be a shift away from the stronger strong dollar
policy that Secretary Bessent referenced.
So, what is your understanding? What do you think the strong
dollar policy actually means?
Seth Carpenter: Strong dollar
policy, that's a phrase, that's a term; it's a concept
that lots of Secretaries of the Treasury have used for a long
time. And I specifically point to the Secretary of the Treasury
because at least in the recent couple of decades, there has been
in standard Washington D.C. approach to things, a
strong dichotomy that currency policy is the policy of the
Treasury Department, not of the central bank. And that's always
been important.
I remember when I was working at the Treasury Department, that
was still part of the talking points that the secretary used.
However, you also hear Secretaries of the Treasury say that
exchange rates should be market determined; that that's a key
part of it. And with the back and forth between the U.S. and
China, for example, there was a lot of discussion: Was the
Chinese government adjusting or manipulating the value
of their currency? And there was a push that currencies should be
market determined. And so, if you think about those two things,
at the same time – pushing really hard that the dollar should be
strong, pushing really hard that currencies should be market
determined – you start to very quickly run into a bit of an
intellectual tension. And I think all of that is pretty
intentional.
What does it mean? It means that there's no single
clear definition of strong dollar policy. It's a little bit of
the eye of the beholder. It's an acknowledgement that the dollar
plays a clear key role in global markets, and it's good for the
U.S. for that to happen. That's traditionally been what it means.
But it has not meant a specific number relative to any other
currency or any basket of currency. It has not meant a specific
value based on some sort of long run theoretical fair value. It
is always meant to be a very vague, deliberately so,
very vague concept.
James Lord: So, in that version of what the
strong dollar policy means, presumably the sort of
ambiguity still leaves space for the Treasury to
conduct some kind of intervention in dollar-yen, if they wanted
to. And that would still be very much consistent with that
definition of the strong dollar policy.
I also, in the back of my head, always wonder whether the strong
dollar policy has anything to do with the
dollar's global role. And the sort of foreign policy
power that gives the Treasury in sanctions policy. And other
areas where, you know, they can control dollar flows and so on.
And that gives the U.S. government some leverage. And that allows
them to project strength in foreign policy. Has that anything to
do with the traditional versions of the strong
policy?
Seth Carpenter: Absolutely. I think all of
that is part and parcel to it. But it also helps to explain a
little bit of why there's never going to be a very crisp,
specific numerical definition of what a strong dollar policy is.
So, first and foremost, I think the discussion of intervention; I
think it is, in lots of ways, consistent, especially if you have
that more expansive definition of strong dollar, i.e. the
currency that's very important, or most important in global
financial markets and in global trade. So, I think in that
regard, you could have both the intervention and the strong
dollar at the same time.
I will add though that the administration has not had a clear,
consistent view in this regard, in the following very specific
sense. When now Governor Myron was chair of the Council of
Economic Advisors, he penned a piece on the Council of Economics
website that said that the reserve currency status of the dollar
had brought with it some adverse effects on the U.S., and in
terms of what happened in terms of trade flows and that sort of
thing.
So again, this administration has also tried to find ways to
increase the nuance about what the currency policy is, and
putting forward the idea that too strong of a dollar in the FX
sense. In the sense that you and your colleagues in FX markets
would think about is a high valuation of the dollar relative to
other currencies – could have contributed to these trade deficits
that they're trying to push back against.
So, I would say we went from the previous broad, perhaps vague
definition of strong dollar. And now we're in an even murkier
regime where there could be other motivations for changing the
value of the dollar.
Seth Carpenter: So, James, that's
been our view in terms of the Fed, but let me come back to you
because there are lots of different forces going on at the same
time.
The central bank is clearly an important one, but it's only one
factor among many. So, if you think about where the dollar
is likely to go over the next three months, over the next six
months, maybe over the next year, what is it that you and your
team are looking for? Where are the questions that you're getting
from clients?
James Lord: Yeah, so when we came into the
start of this year, we did have a bearish view on the dollar. I
would say that the drivers of it, we'd split up into two
components. The first component was a lot more of the
conventional stuff about growth expectations, what we see the Fed
doing. And then there was another component to it where – what we
defined as risk premia, I suppose. The more unconventional
catalysts that can push the dollar around, as we saw, come very
much to market attention during the second quarter of last year,
when the Liberation Day tariffs were announced and the dollar
weakened far in excess of what rate differentials would
imply.
And so, I would say so far this year, the majority of the dollar
move that we've seen, the weakening in the dollar that we've
seen, has been driven by that second component. What we've kind
of called risk premia. And the conversations that, you know,
investors have been having about U.S. policy towards Greenland,
and then more recently, the conversations that people have
been having around FX intervention following the dollar-yen rate
check. These sorts of things have been really driving the
currency up until , when the Kevin Warsh nomination was
announced.
When we look at the extent of the risk premia that we see in the
dollar now, it is pretty close to the levels that we saw in the
second quarter of last year, which is to say it's pretty big.
Euro dollar would probably be closer to 1-10, if we were just
thinking about the impact of rate differentials and none of this
risk premia stuff over the past year had materialized.
That's obviously a very big gap. And I think for now that gap
probably isn't going to widen much further, particularly now
that market attention is much more focused on the
impact that Kevin Warsh will have on markets and the dollar. We
also have, you know, the ECB and the Bank of
England; , house call for those two central banks is
for them to be cutting rates. That could
also put some downward pressure on those currencies, relative to
the dollar. So all of that is to say for some of the major
currencies within the G10 space, like sterling, like euro against
the dollar, this probably isn't the time to be pushing a weaker
dollar. But I think there are some other currencies which still
have some opportunity in the short term, but also over the longer
run as well. And that's really in emerging markets.
So all of that is to say, I think there is a strong monetary
policy anchor for emerging market currencies. This is an asset
class that has been under invested in for some time. And we do
think that there are more gains there in the short term and over
the medium term as well.
Seth Carpenter: So on that topic, James,
would you then agree? So if I think about some of the EM central
banks, think about Banxico, think about the BCB – where the
dollar falling in value, their currency gaining in value – that
could actually have a couple things go on to allow the central
bank, maybe to ease more than they would've otherwise. One, in
terms of imported inflation, their currency strengthening on a
relative basis probably helps with a bit lower inflation. And
secondly, a lot of EM central banks have to worry a bit about
defending their currency, especially in a volatile geopolitical
time. And you were pointing to sort of lower volatility more
broadly.
So is this a reinforcing trend perhaps, where if the dollar is
coming down a little bit, especially against DM currencies, it
allows more external stability for those central banks, allowing
them to just focus on their domestic mandates, which could also
lead to a further reduction in their domestic rates, which might
be good for investors.
James Lord: Yeah, I think there's something
to that. given the strength of emerging
market currencies. There should be, over time, more space for
them to ease if the domestic conditions warrant it. But so far
we're not really seeing many EM central banks taking advantage of
that opportunity. There is a sort of general pattern with a
lot of EMs that they’re staying pretty conservative and more
hawkish than I think what markets have generally been expecting,
and that's been supporting their currencies.
I think it's interesting to think about what would happen if
they're on the flip side. What would happen if they did start to
push monetary easing at a faster pace? I'm sure on the days where
that happens, the currencies would weaken a little bit.
However, if the market backdrop is generally constructive on
risk, and investors want to have exposure to EM – then what could
ultimately happen is that asset managers will simply buy more
bonds as they price in a lower path for central bank policy over
time. And that causes more capital inflows. And that sort of
overwhelms the knee jerk effect from the more dovish stance of
monetary policy on the currency.
You get more duration flows coming into the market and that helps
their currency. So, yes, if EM central banks push back with
more dovish policy, significantly, it could pose some short-term
volatility. But assuming we remain a low-vol environment
globally, I would use those as buying opportunities.
Seth Carpenter: Thanks, James. It's been
great being on the show with you. Thank you for inviting me, and
I hope to be able to come back and join you at some point in the
future if you'll have me.
James Lord: Thank you, Seth, for making the
time to talk. And to all you listening, thank you for lending us
your ears. Let us know what you think of this podcast by leaving
us a review. And if you enjoy Thoughts on the Market, tell a
friend or colleague about us today.
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