The US and Europe are in a currency war.

The US is winning that war.

Continued dollar weakness may cause problems in Europe.



Investors in Europe are more optimistic than they have been in years, but there is growing concern that U.S. dollar weakness could make the euro too strong.



Investors in Europe are more optimistic than they have been in years thanks to a strong economy and buoyant markets. There is a fly in the ointment, however: a growing concern that continued U.S. dollar weakness could make the euro too strong, with negative consequences for corporate earnings and economic growth.



Indeed, why has the dollar weakened so much, and how much further can it go? And equally important, what are the consequences of a stronger euro for Europe?



The cold currency war



The dollar's 10% decline against other major currencies in 2017 and the comment on 24 January by U.S. Treasury Secretary Steven Mnuchin at the World Economic Forum in Davos that a weak dollar is good for the U.S. in the short term all but confirm that the U.S. administration is engaged in what we have called a "cold currency war" - and it is winning.



Cold wars are not fought in open battle (for example, with currency intervention), but with words and covert actions. The words in the cold currency war have been loud and clear, but what is the covert action? We see a combination of recent actions: (i) a fiscal expansion at the wrong time of the economic cycle, financed mostly by additional Treasury debt, and (ii) a Federal Reserve that appears unwilling to respond with monetary tightening over and above what was already planned, while also discussing an inflation overshoot. These actions are sending an implicit but very clear signal to markets: A weaker dollar is the goal. Markets have understood the signal.



The reason the U.S. has gained the upper hand in this cold currency war is that the balance of power is asymmetric. U.S. President Donald Trump carries the bigger stick: the threat of protectionism. And so Europe and Japan have acquiesced; neither has stemmed their currencies' appreciation with words or actions. On the contrary, both the European Central Bank (ECB) and the Bank of Japan have reduced the pace of their bond purchases, and the ECB has even been hinting at ending net purchases later this year.



How long can it last?



The weak dollar dynamic could stay in place for some time, as the incentives for the protagonists in the cold currency war haven't changed. The U.S. trade deficit widened last year and fiscal expansion is likely to draw in additional imports this year, so the Trump administration will probably continue to be interested in a weaker dollar as long as it doesn't lead to a bond market rout. Moreover, by imposing trade tariffs on imports of washing machines and solar panels on 22 January, the Trump administration has demonstrated its willingness to use the protectionist weapon.



Thus, pushback to a "weak dollar policy" from Europe or Japan is likely to remain minimal. Although ECB President Mario Draghi expressed some concern about "currency volatility" and "the use of language" in a press conference on 25 January, it appears unlikely that the ECB will push back more aggressively.



A possible silver lining for Europe



Further significant euro appreciation would pose downside risks for corporate earnings, economic growth and the ability of the ECB to get inflation closer to its target of about 2%. However, by highlighting that the good times for the European economy may not last, a stronger euro could also serve as a catalyst for policy changes that address some of Europe's remaining structural and institutional flaws.



Once a new German grand coalition government has been formed (which seems likely by March), the discussion among European governments about further steps toward a banking union, in particular joint deposit insurance, and further fiscal integration is set to become more intense.



Proposals by French President Emmanuel Macron on further integration met with a surprisingly positive response by the likely German coalition parties SPD, CDU and CSU in their recent paper summarizing the preliminary talks. The devil is in the details, of course, and progress toward a true banking union and a joint fiscal capacity to counter adverse shocks is likely to be evolutionary; it is also likely to be contingent on cleanup of nonperforming loans and reduced sovereign risk exposure on bank balance sheets.



Still, nothing focuses the mind better than an imminent threat, and strong further euro appreciation could serve that purpose. The U.S. is winning the cold currency war, but if Europe responds in the right way, it may become a winner too by completing its economic and monetary union.



