Just as it was beginning to look like the bond market’s luck was finally running out, President Trump made some remarks that all but guarantee that the bond rally will go on for a little while longer.
While it is no secret that US policymakers are not happy with the strength of the US dollar compared to other currencies, Trump went one step further and threatened intervention to weaken the dollar.
Market participants should know by now that the US president is quick to issue threats and almost as quick, sometimes, to go back on them. However, they cannot totally ignore the possibility that the president could follow his threats with action.
Already, the tariffs he has imposed on imports from China and other countries, as well as his attempts to change global politics to suit his own tastes, have brought the world on the brink of recession. Pushing the US Treasury to single-handedly weaken the dollar is not totally out of the question.
If President Trump does see his wishes come true and the US Treasury, together with the Federal Reserve, intervene to weaken the dollar, who would be the winners and who would be the losers?
Very much will depend on how the rest of the world would respond but, as analysts at Societe Generale wrote in a recent report, bonds would be the clear winners.
A flight to safety following US dollar intervention would see investors buying US Treasuries and German bunds. As the European Central Bank (ECB) would probably not want to see the euro appreciating too much, it would respond to the US moves with efforts of its own to weaken the euro.
This would make German bunds the winning assets of the currency war, according to the Societe Generale analysts. Their yields would slide even deeper in negative territory, pushing their prices up and extending their rally.
Other winners would be gold and also, for a very short period after the intervention, of about two weeks, emerging market currencies like the Mexican peso, Russian ruble and Indonesian rupiah would rally, but this would be unsustainable.
Turning to losers, it is worth noting that not all bonds will benefit from a weaker dollar. Corporate bonds, in Europe in particular, would be hurt by the risk-off environment.
In addition to that, on a fundamental level, as European companies’ earnings would be hit by the stronger euro, investors would ask for higher rewards for taking on the risk of their debt.
Equities — which have underperformed bonds severely this year in terms of capital flows, according to analysis by Bank of America Merrill Lynch — would be the big losers of a Trump-launched currency war.
Capital flows into bonds and equities. Source: Bank of America Merrill Lynch Research
European stocks could take the worst hit in case of a currency war started by President Trump, in the opinion of Societe Generale economists. They estimate that a 10% weakening in the US dollar against European currencies cuts European companies’ earnings by around 4%.
The worst-hit sectors would be aerospace and defence, IT and autos, followed by capital goods and luxury goods.
President Trump used to point out to the stock market’s advance as proof that his economic policies were working. It looks increasingly like he’ll have to point to the government bond market instead.