Currencies

16 https://www.spglobal.com/spdji/en/documents/research/sp-500-global-sales-2018.pdf

Currency Policy and Risks

In the Triffin world, the demand for reserve assets causes persistent deviations from the equilibria in currency markets that would balance trade.

This disequilibrium in trade occurs because the real exchange rate is too strong. Exchange rate overvaluation can be redressed by tariffs, as discussed above, or by addressing the undervaluation of other nations’ currencies, as occasionally floated by President Trump, Vice President-elect JD Vance, and former Trump Administration officials like Peter Navarro and Robert Lighthizer.

Currency policy brings different considerations than tariffs do. The principal risk of pursuing a fairly valued dollar is that the policy intervention makes dollar assets less attractive in the eyes of foreign investors. At the time of writing, the yield on ten-year UST debt is roughly 4.25% per year.

Suppose movement towards the currency valuation that would arise in a trade balance equilibrium would result in foreign holders of USTs expecting a 15% reduction in the domestic value of their UST holdings: that represents almost four years’ worth of interest payments, and over a third of all the expected interest over the life of the note. Three-year UST debt yields 4.1%, implying the devaluation would eat more than all expected interest, i.e. the note holder loses money over the life of the security.

These risks can be a disincentive for holding dollar-denominated fixed income securities. If an expected change in currency values leads to large-scale outflows from the Treasury market, at a time of growing fiscal deficits and still-present inflation risk, it could cause long yields to rise. Because significant portions of the economy—like housing—are tied to the belly and long end of the yield curve, such a rise could have material adverse consequences.

This risk will be somewhat compounded if inflation remains elevated. As discussed in the section on tariffs, the results in Gopinath (2015) indicate that a 20% depreciation in the dollar would boost CPI inflation by 60-100 basis points. A one-time adjustment in the currency without second-round effects should be looked through by the Fed as a price-level rather than inflation-rate shift. However if the Fed believed it to persistently shift the rate of inflation rather than just the price level, under standard Taylor rule specifications, it would hike overnight rates by roughly 100-150 basis points.

Whether the Fed decides to offset any price consequences from a weaker dollar will depend on whether it is concerned by so-called second-round effects, that the initial move in currencies is leading to subsequent rounds of price hikes by firms. Second-round effects are highly dependent on economic context, meaning that if there are numerous other inflationary cross-currents, they are likelier to occur. It will therefore be important for the Trump Administration to carefully choose its moment for such a policy change or to coordinate currency policy with deflationary regulatory and energy policy.

The disincentive for holding equities is somewhat mitigated, as earnings rise to offset some of the currency losses. A significant portion of sales made by S&P 500 companies come from abroad16, and those sales are worth more in dollar terms as the dollar depreciates. Earnings will increase as companies are able to increase selling prices. While higher yields may weigh on multiples, the increase in earnings can mitigate volatility.

It is worth repeating that many of these policies are untried at scale, or haven’t been used in almost half a century, and that this essay is not policy advocacy but an attempt to catalogue the available tools and analyze how useful they may be for accomplishing various goals.

Multilateral Currency Approaches

Historically, multilateral currency accords have been the principal means of implementing intentional changes in the value of the dollar. The Plaza Accord of 1985, in which the U.S., France, Germany, Japan and the U.K. coordinated to weaken the dollar, and the Louvre Accord of 1987, which halted such weakness, are generally regarded as successful approaches to adjusting currency levels (though their economic consequences are somewhat more disputed).

Because the value of the dollar in foreign exchange is also dependent on the forces affecting trading partners’ currencies as well, coordination with those partners on the goal of changing the dollar’s value can be very helpful. Today, the two other major currencies are the euro and the renminbi, though the yen is also of import.

As things stand, there is little reason to expect that either Europe or China would agree to a coordinated move to strengthen their currencies. European real GDP growth has been below 1% for almost three years, and the rise of the Chinese auto export industry has Europe so concerned it is implementing its own set of protectionist measures to limit imports. And Chinese domestic growth has been so weak that China has chosen to double down on its mercantilist, export-led model to secure marginal income, much to the rest of the world’s consternation.

China was basically a non-player in global auto exports just a few years ago, and has now rocketed up to be the world’s biggest auto exporter.17 Neither Europe nor China will be in the mood to curtail their industrial subsidies and other market interventions that would reallocate tradeable manufacturing demand away from themselves and toward the United States.

Japan, the U.K., and potentially Canada and Mexico, might prove more amenable to currency intervention, but aren’t large enough in today’s global economy to accomplish the desired end.

Instead, recall that President Trump views tariffs as generating negotiating leverage for making deals. It is easier to imagine that after a series of punitive tariffs, trading partners like Europe and China become more receptive to some manner of currency accord in exchange for a reduction of tariffs.

As currency accords are typically named after resorts where they are negotiated, like Bretton Woods and Plaza, with some poetic license I’ll describe the potential agreement in the Trump Administration as others have done as the prospective “Mar-a-Lago Accord.”

However, there are many differences between the economy today and that of the 1980s. For one thing, gross U.S. debt as a share of GDP is now in excess of 120%, relative to roughly 40% when the Plaza Accord was agreed. That drives concerns about the consequences for the debt market that didn’t exist in the 1980s.

One suggestion put forth in Poszar (2024) is for any accord to incorporate a duration agreement. Poszar’s hermeneutics of the remarks of likely economic policy leaders in a second Trump Administration explicitly links the U.S. provision of a security umbrella to the international financial system, and infers that efforts to reduce interest rates can help finance the security zone. He synthesizes the following Mar-a-Lago Accord from potential policymakers’ remarks:

17 https://www.wsj.com/world/china/china-vehicle-sales-rise-further-boosted-by-stimulus-policies-sales-promotions-3452cca1 “1) security zones are a public good, and countries on the inside must fund it by buying Treasurys; 2) security zones are a capital good; they are best funded by century bonds, not short-term bills; 3) security zones have barbed wires: unless you swap your bills for bonds, tariffs will keep you out.” (Poszar, 2024.)

To strengthen their own currencies, reserve managers must sell dollars. As their currencies appreciate, the United States will receive a competitiveness advantage helping our tradeable and manufacturing sectors.

To help mitigate potential unwanted financial consequences (like higher interest rates), reserve selling can be accompanied by term-out of remaining reserve holdings.

Increased demand for long-term debt by reserve managers will help keep interest rates down, even if there is overall selling of USD fixed income as a result of the currency adjustment. Reserve owners hold fewer USD reserves, pushing their currencies higher, but the reserves they do hold are longer duration, helping contain yields.

If the term-out is into special century bonds as suggested by Poszar, then the funding pressure on the U.S. taxpayer for financing global security is significantly alleviated. The U.S. Treasury can effectively buy duration back from the market and replace that borrowing with century bonds sold to the foreign official sector.

Such a Mar-a-Lago Accord gives form to a 21st Century version of a multilateral currency agreement. President Trump will want foreigners to help pay for the security zone provided by the United States. A reduction in the value of the dollar helps create manufacturing jobs in America and reallocates aggregate demand from the rest of the world to the U.S. The term-out of reserve debt helps prevent financial market volatility and the economic damage that would ensue. Multiple goals are accomplished with one agreement.

But the term-out of reserve debt shifts interest rate risk from the U.S. taxpayer to foreign taxpayers.

How can the U.S. get trading and security partners to agree to such a deal?

1. There is the stick of tariffs.
2. There is the carrot of the defense umbrella and the risk of losing it.
3. There are ample central bank tools available to help provide liquidity in the face of higher interest rate risk. Ex ante, there were also numerous doubts and questions about Trump’s ability to secure improved trade terms from Mexico and Canada, Korea, and China, and yet he succeeded.

Recall that the purpose of official sector currency reserves is to defend the value of the currency in the face of market volatility and finance imports in a potential crisis. The reason reserve managers tend to keep duration risk low is because they need to be able to liquidate reserves to defend their own currencies when volatility spikes.

If they experience losses on their holdings because interest rates increase, they have reduced firepower for defending their currencies. Longerterm debt is less liquid than short-term debt, and crossing bid-offer spreads can be costly in ultra-long-term debt.

This mark-to-market risk of holding longer-term debt can be mitigated via swap lines with the Federal Reserve, or alternatively, with the Treasury’s Exchange Stabilization Fund. Either institution can lend dollars to reserve holders at par against their long-term Treasury debt holdings, as a perk of being inside the Mar-a-Lago Accord.

Such liquidity obviates the risk of mark-to-market loss on long-term debt, since reserve managers will always have access to liquidity at the face value of the debt. As Poszar (2024) points out, the Bank Term Funding Program which the Fed used to respond to the regional bank stresses of spring 2023 provides a model. Holding century bonds is less risky for reserve managers if they have access to swap lines granting them substantial short term dollar liquidity. The desire to maintain access to such swap lines will be a powerful long-term incentive for remaining inside the U.S. security and economic umbrella.

Such an architecture would mark a shift in global markets as big as Bretton Woods or its end. It would see our trading partners bear an increased share of the burden of financing global security, and the financing means would be via a weaker dollar reallocating aggregate demand to the United States and a reallocation of interest rate risk from U.S. taxpayers to foreign taxpayers. It would also more clearly demarcate the lines of the American defense umbrella, removing some uncertainty around who is or is not eligible for protection.