Will US dollar devaluation be Trump’s next sudden move?

President Trump has waged war on the U.S. Federal Reserve (Fed) for more than a year, launching salvos of tweet-bombs laced with criticism and ridicule. Trump’s main points have been that the Fed is too hawkish, and the U.S. dollar is too strong.

Politics have made matters worse. But the Fed shows no interest in taking the more proactive approach to policy that Trump would like to help outflank China. Chinese authorities have not indicated that they will bend on U.S. trade demands. Trump cannot raise tariffs again without risking recession. Fiscal stimulus is unlikely.

The one lever left is the U.S. dollar.

But: A move by Trump to proactively de-value the U.S. dollar would be the monetary policy equivalent of the nuclear option, a weaponization that could set in motion an ugly currency war and a race to the bottom.

Absorbed by Trump’s behavior, most commentary on this war has focused on the implications for Fed independence — not whether the president has a point. It turns out he did, at least last year.

Fed Chairman Jerome Powell made a serious error, thinking the neutral rate was much higher. Markets shamed him into a dovish pivot by year end, but there has been little follow-through: Two small 25 basis point rate cuts, including the one announced September 18, and an end to balance sheet tightening. Powell also continued to pour cold water on expectations that short rates could be another 75 basis points lower by this time next year.

Trump’s frustration with Fed inertia boiled over into a late-August presidential tweet, howling at who was the bigger “enemy”: Powell or Chinese President Xi Jinping. The global manufacturing recession creeped into the U.S., and capital spending is contracting. Estimates are that 30 percent across-the-board tariffs on Chinese imports would be akin to a $2 per gallon increase in gasoline prices.

That’s enough to push the U.S. economy into recession — and the president knows it. 

Thus despite his many tweets – including claiming the Fed has “no guts, no sense, no vision” – Powell and the Fed Board are still not going to give Trump what he wants: Aggressive, reflationary monetary policy.

A strong currency has been official U.S. policy for three decades. The benefits of being the de facto global currency are well known. Trump’s Treasury secretary reaffirmed the strong dollar policy.

But Trump is transaction-oriented, not beholden to taboos he believes do not serve his interests. He has been consistent in his criticism of how undervalued he considers the euro to be and was quick to target China as a currency manipulator on the recent drop in the renminbi.

The Fed’s policy prescription is plain: Cut rates enough to steepen the yield curve. Borrowing conditions might not move much but the effect on the dollar could be significant. It is an epic historical anomaly that almost all the world’s major countries’ sovereign debt trades with a yield below the U.S. over-night risk free rate — a rate profile clearly helping to prop up the U.S. dollar.

The yield curve is ominous. Everyone, including the Fed Board, knows that the U.S. Treasury bond curve is an early but extremely reliable signal of building business risk. Yet the Fed’s official view seems to be that the curve’s inversion is a distortion arising from foreign policy settings: It is different this time and should be ignored. Powell said he will act “as appropriate.”

Translation: Powell will wait until the global slump leads to weakness in domestic indicators like spending and employment before he gets more aggressive. But by then, it may be too late. The Fed faces a complex situation, and Powell is moving in the right direction, albeit very slowly, certainly too slowly for Trump.

Capital markets have reached critical levels. There is a lot of uncertainty in the world apart from trade discussions between the U.S. and China. Something must give.

No one expects a trade deal. The Chinese seem dug in and have prepared for difficult times. Trump has said the economic weakness associated with tariffs is a price worth paying to get to fair trade. The biggest surprise would be the announcement that both parties have come to terms.

This would take the pressure off Trump to resort to the nuclear option.

Francis A. Scotland is director of Global Macro Research at Brandywine Global, a subsidiary of Legg Mason.  His opinions are not are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice. All investments involve risk, including loss of principal.