The Plaza Accord still stands as the best-known multi-national effort to manipulate foreign-exchange markets.

In 1985, the finance ministers of the world’s five most important economies met in the US to solve a problem. Representing France, Japan, the UK, the US and West Germany, they gathered at the Plaza Hotel in New York and their solution become known as the Plaza Accord.

Their concern? An overvalued US dollar, which had nearly doubled on a trade-weighted basis over the preceding five years, largely because the Federal Reserve had raised the cash rate to quell inflation.[1] Their problem? Much of US industry including agriculture was reacting to its loss of competitiveness by lobbying politicians in Washington for tariff protection, while the US was worried that its current-account deficit was swelling. Their answer? The Reagan White House pursued an agreement with these countries to undermine the greenback against the Deutsche mark and yen.

The Plaza Accord still stands as the best-known multi-national effort to manipulate foreign-exchange markets. Perhaps an agreement like this is needed today because the US dollar is soaring again. In fact, the yen is weaker now than it was in 1985 on a real-effective (inflation adjusted) trade-weighted basis – falling to 74.81 on this measure in September this year, its lowest since 1982.[2] But there’s no sign of a new pact, even amid talk of so-called currency wars. Investors can thus expect the greenback to add to its 6% surge since July that has seen it surpass four-year highs when judged on the Federal Reserve’s measure of the US dollar’s strength against widely traded currencies.[3]

It’s easy to explain the US dollar’s spurt– on December 1 it was trading at $1.25 against the euro, $1.56 against the UK pound and 119 yen, a gain of 8%, 4% and 15% respectively from a year earlier. The main driver is that the US economy’s faster growth has boosted expectations that the Federal Reserve will tighten monetary policy by raising the cash rate, at a time when policymakers in the struggling eurozone and Japanese economies are pursuing more promiscuous monetary policies. Investors propel the US dollar when they shift money from euro- or yen-denominated assets into US-dollar securities offering higher returns. It’s likely that the interest-rate differential in favour of US securities will be even larger in two years’ time than it is today. Another boost for the greenback is that the shale revolution has slashed the US current-account deficit to about 2% of output from triple that in 2006. This largely removes a net drag on the demand for the US dollar from the combined activities of importers and exporters. A third propulsion is the haven status of US securities in uncertain times. Higher inflation in the US, though, in theory undermines the greenback but the differential is almost too small to worry about – US consumer prices are rising at an annual rate of 1.3% versus 0.4% in the eurozone and 0.9% (for core inflation) in Japan.

The new era of the mighty US dollar will no doubt prove doubt-edged to the US and world economies. There are advantages for sure, especially for the US, eurozone and Japanese economies. But there are some drawbacks generally tied to rapid surges in the US dollar that investors need to be wary of; namely, pitfalls for the US economy, potential damage to emerging markets with currencies linked, even loosely, in some way to the US dollar and instability tied to the cementing of the US dollar as the world’s premier reserve currency.

Forex markets are notoriously difficult to predict so perhaps the US dollar’s climb will peak soon and all the analysis about what a strong US dollar means will be for nothing. The consequences of currency-induced trade and inflation effects often prove exaggerated because businesses can take cuts in margins and pocket the fatter margins rather than pass onto consumers the full movement in exchange rates. Changes in currency values also have less influence on profits when so much production is based outside developed countries. The US dollar is well short of its 1985 peak when judged against major traded currencies (i.e. not on a trade-weighted basis) so its strength is not the problem it has been in the past.[4] Any attempt at a Plaza-like accord would be harder these days because forex turnover is estimated to be 10 times what it was in 1985.[5] A surging euro would probably be a greater concern for the global economy, anyway, for a strong euro could be enough to send the eurozone into a damaging deflationary spiral. But it’s more likely that investors will focus on what a stronger US dollar means, for the greenback’s surge is well supported by fundamentals.

Plus and minuses

Investors have much to be thankful for if the US dollar keeps rising, even if a sturdier US dollar crimps the US-dollar-value of foreign earnings for S&P 500 companies. A major beneficiary is likely to be the US economy. A mighty greenback could attract so much capital to US-dollar-denominated securities (including US stocks) that long-term interest rates will stay lower than otherwise, even if the Fed is lifting the cash rate. This would mean the Fed has less chance of crunching the US economy as it boosts the cash rate from close to zero to more neutral levels. A stronger US dollar means the Fed would worry less about inflation, anyway, for lower import prices suppress consumer inflation. A rising US currency could even lift the confidence of US consumers, who are enjoying greater spending power due to a drop in the prices of imports and commodities, while some of the capital inflow would be in the form of growth-enhancing investment.

Another advantage is that a higher US dollar helps policymakers in Europe and Japan avoid deflation, their most urgent priority in terms of nurturing the longer-term health of their economies. The sliding euro and dropping yen boost inflation by driving up the prices of imports in Europe and Japan. Another plus is that the higher US dollar helps Japan and Europe trade their way out of their woes by boosting their export competitiveness and lowering appetite for costlier imports. The higher US dollar could thus be doing the world a favour by aiding two large sick economies and the world’s largest economy.

Investors, however, need to be aware of some of the possible drawbacks of a burlier US dollar. The stronger currency could attract so much capital to the US that longer-term US bond yields stay too low. Unconstrained US domestic demand may then re-widen the US current-account deficit and rekindle inflation as a medium-term threat. Thus a situation could arise where a stronger US dollar leads to talk that the Fed will need to raise rates faster than otherwise to stymie inflation and avoid the trade and capital-flow imbalances that bedevilled the world leading up to the global financial crisis of 2008. The opposite, however, could happen, too, when it comes to the Fed’s goal of maintaining price stability. A stronger US dollar could see the US struggle to avoid the deflation taking hold in its trading partners, if the US economy isn’t growing fast enough to generate enough inflation to counter the drop in import prices. If this were to happen, investors may well start to hear talk of another Fed quantitative-easing program, no doubt dubbed QE4.

Then there’s the drag on US exports. Congress, at the prodding of business and unions, could see the falling euro and yen as a currency war that the US is losing. It could take retaliatory steps against imports in consequence. A US dollar at, say, 140 yen could stir protectionism in the US, especially as major US export markets are in such limp condition that the appetite for US goods is curbed anyway.

Dilemmas for decision-makers

Swings on financial markets breed uncertainty and can often lead to global instability, especially when it is the world’s reserve currency that is gyrating. Emerging countries generally tie their currencies to the US dollar, so their trade positions deteriorate as the US dollar soars. China, among other countries, could do without the brake on growth a stronger US dollar threatens via reduced exports as it battles a financial crisis. It at least enjoys some of the benefits from a drop in the price of commodities in US dollars, unlike commodity-exporting emerging countries or Australia. A rising US dollar undermines commodities priced in US dollars because it makes them less affordable in other currencies.

Another problem for the world – and the US – of a rising US dollar is that it cements the greenback’s role as the world’s premier reserve currency, which is a currency that is widely held by governments and institutions among their forex reserves because it is seen as a store of value. While this enhanced status carries the advantages for the US that it reduces interest rates, transaction costs and forex risks and generates seigniorage profits (gains made when the cost of creating money is less than the face value of the money and that new money is used to buy government bonds and thus lower interest rates), it places a dilemma in front of US policymakers. They can either preserve the value of a currency by keeping monetary policy tight enough to keep inflation low or they can supply the extra money the world demands and be troubled by inflation and current-account deficits. US policymakers typically opt for the latter path.

Another problem for the rest of the world is that their banks mostly rely on borrowing in US dollars while their borrowers, in turn, are repaying them in local currency. This currency mismatch, where bank US-dollar liabilities rise with the climbing US dollar, could at the margin lead to instability in the financial sector. The Bank of International Settlements warned in a research paper in 2014 that exchange rates are a key influence on financial stability because of the extent to which local banks borrow in US dollars from global banks, which, in turn, rely on the US money markets for funding. “The pre-eminent role of the US dollar as the currency used to denominate debt contracts” explains why US “dollar appreciation constitutes a tightening of global financial conditions and why financial crises are associated with dollar shortages”, the bank says.[6] Emerging economies with large US-dollar-denominated debts battling slowdowns will not welcome a stronger US currency and the associated tightening of US monetary policy. The Bank of International Settlements estimates cross-border loans to emerging countries reached US$3.1 trillion in mid-2014.[7]

The most appropriate way for policymakers to react to the stronger US dollar, given these concerns? The best thing authorities can do is pursue policies that revive the eurozone and the Japanese economies, for a tighter outlook for monetary policy in these economies would reduce the allure of US-denominated securities. Other than that, they probably should do little if anything. For if officials were to meddle in forex markets, they could trigger unintended consequences. There is no better example of how intervention carries side effects than the Plaza Accord of 29 years ago. It was such a success in terms of lowering the US dollar over the following two years that countries hastily agreed to halt the greenback’s plunge when they signed the so-called Louvre Accord in 1987 – yes, the meeting was held in the Louvre in Paris. But this new pact was too late to stop wider damage, according to many. They claim that the yen’s ascension from 1985 hobbled Japanese exports so much that Tokyo was forced to implement the fiscal and monetary stimulus that led to the poisonous asset bubbles of the late 1980s. The ghost of these bubbles is hovering over the stronger US dollar even today.

Financial information comes from Bloomberg unless stated otherwise.

by Michael Collins, Investment Commentator at Fidelity

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