Weaker dollar outlook and the conflicting realities

Weaker dollar outlook and the conflicting realities

 

How quickly the market shifted from a stronger dollar outlook to a weaker one (basis Donald Trump’s statements) is surprising. A lot still needs to be answered before the weaker dollar strategy fits into all aspects related to the current US and world economy. This note is to express those doubts.  

 

The interest rate differential between the US and Europe or US and Japan remains and is set to widen as US seems to be on a rate hike path while ECB and Japan still talk about supporting their respective economies with monetary easing. How this widening interest rate differential (a manifestation of the growth differential itself or loosely the inflation differential too) fits into a weaker dollar strategy, is something that still needs to be answered.

 

A higher fiscal deficit would increase the supply of bonds and push yields higher in the US which would attract more investments into the reserve currency (USD) as other reserve currencies (EUR, JPY, CHF) struggle to generate yields or are not as stable in the current environment (GBP). The higher fiscal deficit should again result in higher growth, higher inflation therefore higher interest rates. This in turn will fail to fit into a weaker dollar strategy.

 

If there are tax incentives given by Trump (like Homeland Investment Act) to get investment into the US, then the quantum of funds moving on shore could be higher than USD 1 trillion according to the lowest estimates. Thus again a weaker dollar outlook doesn’t gel in with this assumption of attracting funds on shore.

 

In summary a weaker dollar strategy doesn’t fit in with a stronger US economy as compared to a weak Europe and Japan. Thus a weaker dollar can only be achieved with huge intervention by the FED which should again be inflationary increasing the Fed’s balance sheet size. The FED has total FX reserves of USD 118 bn with currencies only adding up to  USD 39 bn as of November 2016. Thus the current ability of the Fed to intervene decisively in the FX markets seems limited unless it decides increase its balance sheet size again.Verbal interventions or tweets by Trump would only go as far (perhaps 5%) to keep the dollar appreciation in check against fundamentals.

 

Generally USD strength or weakness is not so much determined by trade as it is by capital movement globally. USD is the world’s reserve currency and in the current environment no central bank would be keen to shift reserves from USD to EUR or JPY given the lack of yields plus the uncertainty surrounding the EU in 2017. For Trump to achieve a weaker dollar is going to be difficult task given the current growth and inflation differential between the US and other DMs.

 

Possibilities are that a weaker USD strategy is aimed at China (his statement was aimed specifically at China) which can be achieved basis bilateral talks and the rest of the market functions the way it efficiently was basis the assumptions on US growth and fiscal deficit post Trump elections.

 

Too soon to form a view without all questions answered. I would see a weekly closing below 99.5 on the dollar index as a confirmation of an approaching dollar weakness. Meanwhile we can continue to expect dollar trades to surprise us on with conflicting themes.