Headwinds for the US dollar

10 Apr 2017

Key takeaways

  • The Fed now expects to start reducing the size of its balance sheet in 2017, which may slow its path of rate hikes
  • The economy appears to be on a self-sustained moderate growth path, both in the US and globally
  • It is unlikely for the US dollar to continue strengthening much from current levels

The Federal Reserve (Fed), the European Central Bank (ECB), Trump, and the French election have been some of the factors influencing the USD recently.

Among these, the Fed has been the most predictable factor, as markets have long been warned that three hikes are likely in 2017. A new development is that, barring surprises, the Fed now expects to start reducing the size of its balance sheet in late 2017, significantly earlier than previously thought. On the day of the release of this Fed news (reported in the FOMC minutes of March 2017), stock prices reversed a strong morning rally while bond yields fell. There is some expectation that a balance sheet reduction process may cause the Fed to slow its path of rate hikes. The Fed will likely tread carefully as the uncharted process of balance sheet reduction starts, given that there is great uncertainty on how financial markets will be affected.

Markets continue to fret over the possibility of a win by Le Pen in France in May even though recent political developments suggest the worst fears may not materialize. The euro economy is doing well, though core inflation remains far from target, ensuring continued negative rates and quantitative easing (QE) for the balance of 2017 in spite of impatience by Germany (and some other members) who would like to end QE as soon as possible: more guidance on tapering of QE and raising of the negative deposit rate is likely by June if current economic trends continue. In the end, the euro and the Japanese yen are more likely to be driven by rate differentials with the US, than politics in the Eurozone. On that score, US yield spreads to both German Bunds and Japanese JGBs appear to have stabilized at very wide levels and narrowed somewhat since early March.

At this time, the promise of more clarity on Trump’s economic policy regarding trade, tax cuts and infrastructure spending has been delayed well beyond mid-year, after the unexpected failure of the repeal of Obamacare. Trump’s popularity has fallen to historically low levels for this early phase of his presidency, and the administration remains embattled on a number of fronts. It is possible that gridlock in Washington will continue for much of 2017, deflating some of the optimism that led to strong animal spirits in stock markets, business and consumer confidence. On the other hand, the economy appears to be on a self-sustained moderate growth path both in the US and globally. It could be argued that a large US economic stimulus at this stage of the cycle is not advisable from the Fed’s perspective in any case, given that inflation and employment conditions are near target already. Barring unexpected negative developments from a protectionist Trump agenda, damaging political developments in European elections, a sharp Chinese slowdown, or other catalysts that could lead to sharp declines in stock markets and economic activity, the main global macro scenario calls for a continued moderate pick up in world growth and inflation in the next year.

In such a benign outcome – and provided the controversial border-adjusted tax proposal by US House speaker Ryan does not gain traction in the US – it is unlikely for the US dollar to continue strengthening much from current levels. A factor that would be a headwind for the US dollar at this time is the narrowing of growth and inflation differentials with better world growth, and the concomitant reduction in monetary policy divergences under the reality of an ultimately delayed and limited Trump economic stimulus program. A second important factor is that the US dollar has rallied broadly by more than 20% in the past five years and is now quite expensive on a number of valuation metrics against many G-10 as well as emerging market (EM) currencies. Should there be a risk-aversion event, a safe-haven currency such as the Japanese yen could rally strongly. The US dollar would also be vulnerable vs. the euro and other cheap G-10 majors (e.g. the Swedish krone) depending on the catalyst for risk-aversion. Conversely, should world growth surprise on the upside, EM and commodity currencies would benefit more than the US dollar in a convergent growth world. The long term position of the real US Broad dollar index shown in the graph below suggests the precarious nature of the dollar’s current levels when US growth is no longer exceptional and world growth is picking up.

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