How Mnuchin’s words in Davos could send the US dollar spiralling

At last week’s World Economic Forum (WEF) in Davos, no one made US Treasury Secretary Steven Mnuchin refer to the benefits to the United States accruing from a weaker dollar. He chose to. Mnuchin may have added to the greenback’s existing woes by casting doubt over the Treasury’s long-standing adherence to a strong dollar policy.

“Obviously a weaker dollar is good for us as it relates to trade and opportunities,” Mnuchin said on Wednesday. Although his comments overall were even-handed and he shouldn’t be accused of directly trying to talk the greenback down, Mnuchin doesn’t seem to be on the same page as many of his predecessors.

As he said on a WEF panel on Thursday, presumably as part of an attempt to persuade markets that the importance of one comment on Wednesday had been overblown, Mnuchin nevertheless noted that his position “is perhaps slightly different from previous Treasury secretaries” who have argued for a strong US dollar. Mnuchin backs free and floating currencies.

That said, on Friday he told CNBC a strong “long-term dollar” is in US interests.

But by deviating, however subtly, from the straightforward strong US dollar mantra, Mnuchin has effectively let the currency market think it knows both that he himself has no issue with a weaker greenback in the short term and that the US government, which doesn’t like intervention by others in the currency market, would be a bystander to such a move.

“Ultimately, I want to see a strong dollar,” President Trump said on Thursday, arguably as part of a damage limitation exercise, but markets cannot have failed to notice his use of the word “ultimately.”

Trump may have decided to comment because if overseas investors perceive the US Treasury is institutionally calm about another fall in the greenback’s value, they could start to demand higher yields to compensate them for holding the depreciating currency just when the US government’s borrowing needs are on the rise following the passage of taxation reform in December.

In 1971 President Nixon triggered a devaluation of the US dollar by unilaterally cancelling its international convertibility to gold. US Treasury Secretary John Connally famously told his G-10 colleagues that the “dollar is our currency but it’s your problem.”

But by 1978 the falling value of the dollar was very much the US’ problem. President Carter’s administration issued Carter Bonds – US Treasury bonds denominated in West German Deutschmarks and Swiss francs – in part to shore up the value of a plummeting US dollar.

The greenback only truly recovered with the much tighter monetary policy adopted by Paul Volcker at the Federal Reserve after August 1979. By 1985, the greenback had risen so high that six nations agreed the Plaza Accord in September of that year to drive it down. Yet less than two years later the same six countries signed the Louvre Accord to try to halt the greenback’s post-Plaza fall.

Fast forward to President Clinton’s first term and in 1993 Treasury Secretary Lloyd Bentsen had no qualms about calling for a lower dollar/yen exchange rate as a way of addressing the rising US trade deficit with Japan. But with Bentsen succeeded as Treasury Secretary by Robert Rubin in January 1995, the strong dollar policy was born.

While not directly attributable to Bentsen’s use of the dollar to strong-arm Japan, US Treasury yields soared in 1994 as their prices fell. Rubin’s adoption of the strong dollar policy helped arrest its decline while in the process giving comfort to overseas investors who, with fears about a falling greenback somewhat assuaged, felt happier returning to the market to buy Treasuries to fund Uncle Sam.

Additionally a rising greenback reduces the risk of higher inflation through the import channel even though it makes American exporters less competitive.

In truth, Robert Rubin and his successor Larry Summers calibrated a strong dollar mantra where the rhetoric satisfied market participants that was the US Treasury’s official stance even if the greenback was trading on the soft side in the real world. The Treasury could have a policy of benign neglect towards the greenback but with markets still believing a strong US dollar policy was in place.

Mnuchin hasn’t disowned the strong US dollar mantra in its entirety but his approach to the greenback seems more nuanced. His problem is that markets don’t always do nuances. As a consequence of a few words uttered in the Swiss Alps last week the US dollar could begin a new downhill slide.