Treasury Secretary Mnuchin breaks with tradition by declaring that a weaker dollar is good for U.S. trade, prompting a further slide in the currency.

U.S. Treasury Secretary Steven Mnuchin broke with tradition in January by declaring that a weaker dollar is good for American trade. The greenback extended its 2018 drop against most other currencies after Mnuchin's comments at the Davos meetings. Mnuchin is the first Treasury Secretary to diverge from the mantra espoused by Robert Rubin, Treasury Secretary under President Clinton, that "a strong dollar is in the nation’s interest."

A weak dollar would be consistent with some of the economic goals of the Trump administration.

The dollar floats as freely as any currency. The Treasury's pot of money for currency intervention is tiny, and large advanced economies rarely intervene in their currency markets. While we don't believe the comments signal a new “dollar policy,” some in the markets viewed it as a weaker dollar strategy. Not coincidently, a weak dollar would be consistent with some of the economic goals of the Trump administration. It would improve U.S. manufacturers' competitiveness, reduce the trade deficit, and boost the government’s efforts to aid the manufacturing sector.

Current account and risk appetite fuel dollar losses

While Mnuchin's comments paved the way for more losses in the greenback, they weren’t the key to the dollar's weakness. Its decline to three-year lows in January was also driven by the U.S. current account deficit and risk appetite. The dollar fell between 4% and 7% from its peak in November 2017, with about half of the depreciation in January. Exchange rates are prices, and like other prices, they are determined by the balance in supply and demand. The dollar declines when the supply rises relative to demand, and the currency depreciates to entice new buyers and discourage new supply.

A widening deficit

The biggest single source of the global supply of dollars is the current account deficit. The United States pays dollars to the rest of the world for the goods and services it imports. These typically exceed the dollars the United States earns by exporting goods and services. So, what changed recently? The current account deficit is set to start growing again as the economy expands, and the benefits of higher energy exports start to wane. The trade deficit in November was the largest since the 2008 financial crisis. As a result, the supply of dollars is rising and is set to increase from this source.

The state of risk appetite

A second factor for the decline in the dollar is the state of risk appetite. Stronger risk appetite is associated with U.S. investors buying risky foreign assets. As U.S. residents buy assets, along with goods and services from the rest of the world, the supply of dollars increases. Strong growth in the eurozone has played a role in the dollar’s value. Growth among eurozone countries and a decline in the political risk premiums attached to their assets have raised the attractiveness of European assets to U.S. investors. Higher supply of dollars will cause the value to fall unless foreign demand for U.S. assets rise. But, there is no real sign of increased demand for U.S. assets.

This is partly due to valuations given the rally in U.S. equities. And there is no sign of any change in net foreign direct investment (FDI) flows. The United States typically has large FDI inflows and outflows, and the net position can be quite volatile from quarter to quarter. This is also a key reason why interest rates are rising. International investors tend to buy U.S. assets when there are prospects for higher returns, and they may not be seeing higher returns ahead.

Next: Wages and inflation in Germany

More from Macro Report
Download the Macro Report (PDF)

We are seeing a return of the threat of protectionism in the United States.