US Dollar: The only way is up?
Nick Stamenkovic - 24th November 2016
A gentle upward trend in US Dollar index from its May low turned exponential in October and ballistic since 8 November. All the old reasons to prefer the Dollar have been dusted down: yield-hungry investors attracted by an impending Fed tightening, the fattening of the premium in US Treasuries versus European bonds and the revival of confidence in US economic growth fuelled by Trump’s reflationary agenda.
But the story doesn’t end there.US presidential elect Trump’s pro-US growth stance has propelled the S&P500 to a record high as bond investors take fright. His proposals for compulsory repatriation of US overseas earnings have been touted by some as another Dollar supportive factor, although the timing and extent of such a move is unclear.
Technical factors add another leg to the bull case: ill-timed US money market reforms have exerted upward pressure on $ LIBOR rates since mid-year. US investors have swiftly exited prime money market funds for the safety of government money market funds, tightening the supply of Eurodollars. The dis-intermediation of the US banking system is raising financing costs for countries outside the US, posing downside risks to growth elsewhere.
The continuation of large-scale asset purchases by the ECB and Bank of Japan provides an increasingly sharp contrast with US monetary policy intentions. As European and Japanese investors take hedged positions in higher-yielding foreign bonds, there is talk of a “global Dollar shortage”. Rising capital flight, meanwhile, has taken its toll on EM currencies. All roads lead to US Dollar appreciation.
However, there is no such thing as a sure bet in a major currency. The Dollar’s recent ascent could be short circuited if a negative feedback loop on the world’s largest economy halts further Fed tightening.
Currently Mr Trump appears intent on dismantling the Trans Pacific Partnership (TPP) but it is premature to rule out more aggressive anti-trade measures in the future. Indeed, any clamp down on Chinese imports and/or raising tariffs by the US authorities would prove counterproductive, threatening tit-for-tat measures by an increasingly nationalistic regime in China. This would threaten the current hegemony of the US Dollar.
The Dollar faces additional hurdles over the medium-term. Notably, financing the so-called “twin deficits”, a burgeoning budget deficit and a worsening external position, could become an increasing constraint on the US currency. This was the case during the Reagan era of the mid-1980s. Will a looser fiscal policy be accompanied by a tighter monetary policy or a looser one? Especially, if the president-elect replaces Janet Yellen in early 2018 with someone more malleable.
Recently, China has significantly lowered its exposure to Treasuries, diversifying away from US assets. Japan, however, may yet prove an offsetting influence. Increased jitters about deteriorating internal and external balances could prompt foreign investors to demand a higher risk premium on US assets, including a weaker Dollar.
Positive Dollar sentiment looks set to persist near-term but mounting fiscal/political concerns could come back to haunt the currency. In particular, Sterling would stand to gain if worries about a hard Brexit prove wide of the mark.
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