Jefferies

Economics and Strategy

Buying BTPs and Intervening in FX Markets: What’s Next in the Trade War?

— David Zervos, Chief Market Strategist

According to the Italian newspaper Corriere della Sera, Trump offered to help finance Italy's 2019 public borrowing when he met with Giuseppe Conte at the end of August. And while most folks have brushed off this purported overture as “incompetent bluster,” there are plenty of reasons why he might consider such an action.

First, though, there is the question of whether he can even unilaterally execute such a move. And the answer is firmly yes. Now, he could NOT direct the Federal Reserve to purchase BTPs (Italian government bonds) in the System Open Market Account (SOMA). He has no authority to do so, and further, the SOMA can hold only Treasuries, Agencies, and short-dated Munis. However, he can ask the Treasury secretary to direct the NY Fed (as its agent and banker) to buy BTPs on behalf of the Exchange Stabilization Fund (ESF).

For those unfamiliar, the ESF contains assets held in Treasury accounts at the Federal Reserve. It is a fund with approximately $100 billion in assets (and $50 billion in liabilities), and it has long history going back to the 1930s. And as its name suggests, it is used primarily for operating exchange rate policy via the purchase and sale of assets denominated in foreign currencies. If you want to brush-up on the details, here are the descriptions of the fund on both the Treasury and NY Fed websites:
https://www.treasury.gov/RESOURCE-CENTER/INTERNATIONAL/ESF/Pages/esf-index.aspx
https://www.newyorkfed.org/markets/international-market-operations/foreign-reserves-management 

I suppose it’s worth noting that the NY Fed seems to believe it has some decision-making power with regards to the ESF, while the Treasury thinks nothing of the sort. My best guess here is that this is just typical NY Fed mandate overreach and that the Treasury can largely do whatever it wants. As such, it’s worth reading this particular passage from the Treasury description of the ESF carefully:

“The ESF can be used to purchase or sell foreign currencies, to hold U.S. foreign exchange and Special Drawing Rights (SDR) assets, and to provide financing to foreign governments. All operations of the ESF require the explicit authorization of the Secretary of the Treasury ("the Secretary"). The Secretary is responsible for the formulation and implementation of U.S. international monetary and financial policy, including exchange market intervention policy. The ESF helps the Secretary to carry out these responsibilities. By law, the Secretary has considerable discretion in the use of ESF resources.”

As stated above, the secretary can basically do whatever he wants. But let’s consider the “whatever he wants” bit in a moment. First, what’s actually inside the ESF at present? Here are the annual and monthly balance sheet reports:
https://www.treasury.gov/resource-center/international/ESF/Pages/reports.aspx

Right now it appears the fund contains about $6 billion in EUR-denominated securities and $6 billion in EUR-denominated deposits/repo. It also has about $2 billion in JPY-denominated securities and $6 billion in JPY-denominated deposits/repo. The rest of the nearly $100 billion in assets are held in SDR and USD. For the purposes of the BTP discussion, it’s worth noting that the EUR securities are only of the German, French and Dutch varietals. So what stops Trump from saying, “Hey, let’s dump 6 yards of negative-yielding core stuff to buy 6 yards of 3%-yielding BTPs.” NOTHING AT ALL. Further, why are his folks at Treasury holding all this SDR? After all, 10% of the SDR is RMB now (does Trump even know he is long RMB?!?). Maybe he can help out his friend Giuseppe by knocking out some SDR, too (or at least the Chinese portion of the SDR for a start).

All of this said, we are not talking about large sums: maybe $20-40 billion in purchases of BTPs max before the capital buffer wears thin. And with Italy needing to refinance something like $400 billion next year, it hardly seems helpful. Nonetheless, the symbolism and the “announcement effect” could be extremely powerful, especially initially.

Now let’s get a little more serious and think about how far Trump can go with this fund. Can he just do whatever he wants in terms of sizing? In particular, what I want to consider here is, can the Treasury Secretary add additional capital to the fund in order to grow the asset base, or would Congress need to approve this? I don’t know, but he could certainly try. Or could he figure out a way to let the fund run a negative capital position by pledging other assets to the Fed, such as gold. (There is probably about $400 billion if they consider going down that path.) This little ESF piggy bank, aka the “trade war chest,” could become a behemoth.

Continuing down this hypothetical ESF behemoth path, let’s imagine that once he is done with NAFTA and China, Trump goes for Germany – the country with the largest trade surplus by far! With Germany deemed a “manipulator,” he could seek to weaken the USD versus the EUR through intervention – in large scale! But instead of taking the EUR proceeds from USD sales and rolling them into Bunds, he could help his buddy Giuseppe and any other peripheral country that wants to play ball. After all, they are not the manipulators, they are just part of the veil being used by the Germans to create a weak currency for themselves.

What’s the bottom line here? Well, if Trump wants to build a “Weapon of Mass Destruction” for the trade war, a bigger and badder ESF is just the ticket. He could topple ANYONE with that ballooned asset base. And if he plays his cards correctly with Europe, he may even bring an end to the existing structure of German-imposed fiscal and monetary discipline that has destroyed an entire generation of peripherally domiciled European citizens. I for one am very excited to watch the coming trade fireworks!