This piece discusses dollar propsects in light of it’s 2017 retracement and the impossible trinity of fiscal expansion, independent US monetary policy and dollar jawboning which the Trump adminstration seems to be pursuing (alongside prospects for US and foreign monetary policy). If Trump eventually delivers a substantial fiscal expansion the impossible trinity seems most likely to be resolved by the dollar again re-strengthening, especially if Trump’s fiscal plans include a Border Adjustment Tax (BAT). But the ride could well be bumpy, likely increasing FX trader’s reluctance to take directional USD views, given:
(i) Potential dollar jawboning by the Trump administration allied to likely greater market scepticism on the Trumpflation trade in light of the recent retracement (“we won’t get fooled again” although positioning is now cleaner);
(ii) We might not get full visibility on the US fiscal plans for several months, despite Trump’s recent pledge to announce a “phenomenal” plan in the next couple of weeks, plus their direct macro impacts probably won’t be felt until 2018.
(iii) Possible risk-negative global trade disputes breaking out. The dollar could neverthless rise in such a “Trumpanic” scenario albeit more selectively than with “Trumpflation” – most obviously probably against risk-positive curencies such as GBP, CAD, AUD and NZD but struggle against risk havens such as JPY, CHF (and possibly EUR) which have recently suffered Trump’s ire.
Given (ii) the FX market will likely continue focussing on whether the Fed will follow through on it’s December expectation of three 2017 rate hikes (currently only two are fully priced by end-year, with a 35% chance of three but only a 30% chance of a March hike). While there’s some market expectation that Fed Chair Yellen will this week echo recent relatively-hawkish Fed commentary, she seems likely to instead reiterate her existing position (keeping options open). A flat Phillips curve (weak wage growth) and tigher US financial conditions represent headwinds to three 2017 Fed rate hikes and hence dollar upside (I demonstrate below that the dollar’s been closely correlated with US-foreign yield gap moves and that term premia have been important in driving US yields). Conversely, I’d fade recent discussions of early ECB QE tapering and the BoJ shortly scrapping it’s Yield Curve Control policy, implying USD support versus EUR and JPY (with EURUSD also potentially suffer from jitters as the French election approaches, see my November analysis).
Post-election Dollar days short-lived as Trump prioritises protectionism: waiting for fiscal news after dollar position clearout
The initial strong dollar and US Treasury yield increases which followed Trump’s election victory, driven by market hopes for a strong fiscal expansion and (consistent with my pre-election analysis), have retraced in 2017. Indeed, the charts below illustrates that the dollar has been hit particularly hard (US equities have been even less perturbed than US yields) although it has continued to closely follow US-foreign yield spreads, suggesting that the dollar’s retracement doesn’t reflect higher FX risk premia.
That reflects a combination of:
- Erosion of market hopes for a Trumpflation environment (provoking faster Fed rate hikes). The prioritisation of Trump’s more protectionist election pledges (withdrawing from TPP, signalling NAFTA renegotiation, committing to build the Mexican wall, surprisingly criticising German and Japanese FX policy) rather than spelling out a cohert fiscal plan have elevated market concerns (I discuss below how this could possibly morph into trade wars and a ‘Trumpanic’ environment).
- The unwind of substantial long-dollar positioning. The latest CFTC data (3 Feb) reports speculative bullish USD currently at their lowest since mid-October (USD18.3bn) as speculators have squared up all of the long positions established after Trump’s victory. Of course, the corollary of such cleaner positioning is greater dollar upside sensitivity to any positive fiscal news (see further below).
Broad based recernt dollar retracement: even EM FX not down much since election
It’s noteworthy just how broad-based recent dollar weakness has been. Indeed, the two charts below illustrate that since start 2017 the only mainstream currency which the dollar has appreciated against has been the Turkish Lira (TRY). And the recent retracement means that the dollar’s overall gains following Trump’s victory are generally fairly modest: among the G10 USDJPY leads the way, helped by the BoJ’s Yield Curve Control policy in a environment where FX moves have been tightly linked to relative yield curve fluctuations (see second Chart above): you could certainly argue that the BoJ “got lucky” with Trump’s victory, although the obvious corollary is greater focus on Japanese FX policy (but I don’t expect that to result in .
There are several other notable findings: (i) GBPUSD is up overall since November, as BoE rate expectations have been revised up in light of continued resilent UK macro data (I discuss how the true Brexit test is yet to come here and how UK net exports are likely to disappoint here); (ii) the largest recent gains have been made by AUD and NZD, reinforcing the previous point that market concerns about Trump’s priorities hasn’t transalated into greater risk aversion; (iii) The dollar’s post-election rise against EM (ex TRY) currencies has generally been fairly muted i.e. generally less than 5% but more typically around 2%.
This doesn’t particularlty susprise me – my US election preview argued that: (i) the dollar was likely to strengthen upon an (underpriced) Trump victory; (ii) improvements in EM macro fundamentals (current account and fiscal deficits, less foreign currency denominated debt and lower inflation) would help shelter EM FX from dramatic sell-offs; (iii) Turkey’s macroeconomic and political weaknesses made TRY a likely outlier in this relatively-sanguine story.
Term premia continue to drive US yields (as I anticipated)
My December analysis argued that rises in term premia back to more normal levels were likely play an important role in supporting higher US yields, and hence the dollar. And New York Fed’s yield curve model results confirm that hypothesis. Specifically, the two charts below illustrate that higher term premia have been important drivers of rises in both 2-year and 10-year Treasury yields and their more recent retracements. The wrinkles here are that the term premium’s role at the shorter end has recently been larger than previously and that the 10-year risk free rate has also risen by 20bp since the election. But with Treasury term premia remaining at historically-low levels their return to more normal levels will tend to support US yields and the dollar.
Trump’s impossible trinity (trilemma): eventual dropping resistance to dollar strength?
A fundamental issue that helps explain the dollar’s recent rollercoaster ride is that Trump’s policies contain internal inconsistencies. Specifically, Trump’s policies suffer from an impossible trinity (or trilemma) of:
(i) Campaign promises of substantial fiscal expansion. While the details have yet to be spelt out, Trump’s 9 February comment that he will announce a “phenomenal” tax plan in the next couple of weeks follows previous hints that he is considering a Border Adjustment Tax (BAT) to finance a reduction in the relatuvely-high US corporate tax rate (although confusingly he also previously argued that BATs were “too complicated”).
(ii) A desire to have independent US monetary policy. Indeed, Trump criticised Yellen and the FOMC for holding back on necessary interest rate rises to allegedly help Obama. Unfortunately for Trump,.
(iii) An apparent aim of trying to avoid dollar appreciation, as that would jeopardise his campaign pledge to boost US manufactuing (the ISM survey new export order balances are already flashing an amber warning, see chart below). Trump has recently controversially argued that China, German and Japan are manipulating their currencies for comptitive advantage, with the US being cast as the victim (on 17 Januray he argued that U.S. companies “can’t compete with (China) now because our currency is strong and it’s killing us.”)
Unfortunarely for Trump, fundamental economic forces mean that you can’t have (iii) if you also want (i) and (ii). Specifically:
- Tighter US monetary policy is the inevitable corollary of expansionary fiscal policy, and that will support dollar appreciation (policy divergence). Indeed, Charts above illustrated the recent tight link between the dollar and US-foreign yield spreads.
- BATs have been much-discussed as supporting up to a 25% dollar appreciation – essentially to eliminate the higher US import prices and lower US export prices itially generated by the BAT. Since a BAT doesn’t impact national savings and investment it can’t alter the trade deficit (although the real-world impact could well be more complicated than that simple reasoning). Relatedly, my US election preview argued that potential tax breaks for US corporates repatriating foreign earnings would generate substantial capital inflows into the US, again supporting dollar strength (as
The path of least resistance out of this trilemma will likely be for the Trump administration to gradually downgrade it’s aim of stalling the dollar strength. It’s basically impossible to hold back market forces for long without without the impacts spilling out somewhere, causing economic and US reputational damage. While FX intervention to maintain an artificially low exchange rate faces less immediate pressures than trying to defend an overvalued one, as FX reserves are being accumulated rather than run down, those And note that China’s recent FX interventions have been to artificially strengthen the yuan), . That said, it could well take time for Trump to come around to this conclusion (the hope is that he’s being educated by old habits could well die hard so we could well see periodic criticisms of foreign FX/monetary policy and some jawboning of the dollar.
What if Trumpflation morphs into Trumpanic as trade wars are triggered?
But it’s impossible to rule out the scenario where Trump insteads reacts to the trilemma’s policy constraints by following through on his election promises of labelling China a currency manipulator and imposing substantial tariffs on US imports from China (Trump mentioned 45% when campaigning) eventually leading to trade wars and strong risk off (‘Tumpanic’). While Trump recently yielded to Chinese pressure to reaffirm his support for the ‘one China’ policy he has also recently placed substantial political capital in sticking to other contentious campaign pledges (Mexican wall project, executive order trying to ban travel from seven mainly Muslin countries) and the White House has been somewhat chaotic (e.g. the resignation of Trump’s National Security Adviser). And in January US Commerce secretary Wilbur Ross argued that “China is the most protectionist of the very large countries…they talk much more about free trade than they actually practice.”
That’s despite recent Chinese FX intervention holding back sharper Yuan depreciation: Chinese FX reserves fell below $3 trillion for the first time in December, down around 25% from mid-2014 (see Chart). So any US pressure to more freely float the Yuan would actually accelerate dollar strength, although it would likely be resisted by the Chinese authorities given financial stability concerns. And recent Chinese official comments indicate that they would likely eventually retaliate against an aggressive US move (although they’ve been portraying themselves as strong free trade supporters).
So it’s impossible to rule out global trade disputes arising, which would be very risk-negative and economically damaging (while the realisation of this should reduce it’s probability, that didn’t prevent Brexit). The dollar would likely still rise in such a “Trumpanic” scenario, although in a more selective/dispersed way than in a “Trumpflation” scenario. After all the dollar apppreciated during the global financial crisis despite the US being at the epicentre as capital returned to the US helped by US Treasuries’ traditional safe haven role.
Specifically, the dollar seems most likely to rise against risk-positive curencies such as GBP, CAD, AUD and NZD in a “Trumpanic” scenario. But it would be more likely to struggle against risk havens such as JPY, CHF (and possibly EUR). Such an outcome could well politically suit Trump given his recent criticisms of Japanese and German policy, while CHF seems to fit many of the US Treasury Department’s currency manipulation conditions.
Fed will remain in focus given fiscal uncertainties: Yellen likely to repeat existing messages this week
Given the uncertainties about US fiscal stimulus – with full visibility on plans probably not achieved for several months (despite Trump’s recent pledge), plus their direct macro impacts probably won’t be felt until 2018 – markets will remain preoccupied with trying to discern whether the Fed will follow through on it’s December expectation of three 2017 rate hikes. Currently only two 2017 rate hikes are fully priced by end-year (around a 35% chance of three) but only a 20% chance of a March hike.
A key focus this week will be Fed Chair Yellen echoes recent marginally-hawkish Fed comments at her semi-annual Humphrey Hawkins testimony: (i) Chicago Fed’s President Evans (voter, dove) argued that he’s slowly leaning toward three 2017 rate hikes, although his official call remains for two; (ii) San Francisco Fed President Williams suggested that a March rate hike shouldn’t be considered as off the table; (iii) Philadelphia Fed President Harker (voter) argued that “March is on the table” given Labour market strength and his desire to not fall behind the curve, although “it depends on how the data evolve.”
Yellen could well be a bit more nuanced, not offering strong guidance on March with the aim of keeping the Fed’s options open (given uncertainties) and not moving markets in current febrile conditions. So Yellen will probably reiterate her 12 January views that near-term risks to the Fed’s economic outlook are “pretty balanced”, inflation is “pretty close” to target and the labor market is “strong” with wage growth “beginning to pick up”. While January’s wage growth retracement (2.5% y/y from 2.8% previously) and rise in U3 and U6 unemployment rates (to 4.8% and 9.4%) provides some limited room for dovishness, the Fed will never place much weight on single data points and employment growth remains strong. Yellen will also likely lean on the small innovations in the 1 Febuary FOMC statement, which placed greater weight on the recent improvement in consumer and business surveys (see Charts below) but remained ess upbeat on ‘hard’ US data and noted ‘still low’ market inflation compensation measures (see Chart).
On fiscal policy I expect Yellen to follow Vice Chair Fischer’s recent template in arguing that while there’s “significant uncertainty” over fiscal prospects the Fed is focused on achieving its dual mandate for inflation and jobs (i.e. ducking the question somewhat). She seems less likely to go as far as St Louis Fed President Bullard (non-voter) in explicitly arguing that the fiscal policy uncertainty means that the Fed should delay hiking (because “It is unlikely that fiscal uncertainty will be meaningfully resolved by the March meeting….Why not wait until that gets resolved?”)
Headwinds to three 2017 Fed rate hikes
Obviously the extent and timing of any US fiscal stimulus remains a key variable in Fed thinking. Unfortunately, the current fiscal policy uncertainty may not dissipate until later in the year despite Trump’s recent pledge to announce a “phenomenal” plan in the next couple of weeks. But given that their direct macro impacts probably won’t be felt until 2018, the Fed will have plenty of time to react as the fog starts clearing.
But there are several headwinds to the Fed’s December plan to raise rates three times in 2017, even if we set aside the potential previously-discussed ‘Trumpanic’ scenario. Indeed it was notable how quickly the market initially bought into the Fed’s three rate hikes profile, given it’s romancing of Trumpflation, after long-standing scepticism.
First, I’ve argued for a couple of years that a relatively-flat US Phillips curve (probably driven by technology advances and other structural changes) will constrain the pick-up in wage inflation and hence encourage greater Fed dovishness. Indeed, the flatness of the Phillips curve in the simple chart below indicates that U3 unemployement will have to fall to around 4% before the core PCE deflator rises to the Fed’s 2% objective (1.7% latest). And it’s not inconceivable that the Fed could eventually mimic the BoE’s recent reduction in their estimate of the equilibrium unemployment rate.
Second, the recent tightening of US financial market conditions – overall higher yields and dollar strength since November (notwithstanding their recent retracement) with some offset by continued equity market strength (see Charts above) – will tend to reduce the urgency of Fed policy normalisation. Essentially the market has been doing the Fed’s work for it.
Fade fears of early ECB tapering and BoJ abandoning YCC (dollar supportive)
The market has recently been flirting with the idea that the ECB will be forced to taper its QE purchases relatively soon (given that German inflation has been rising close to 2%) and that the BoJ will shortly be forced to abandon its Yield Curve Control (YCC) policy (given that it will likely prove wide of the mark, tending to support USD against EUR and JPY
Both of those concerns seem overstated in my opinion, and hence should be faded – hence providing support for USD versus EUR and JPY (EURUSD could also potentially suffer from jitters as the French election approaches, see my November analysis) – although at the margin the BoJ risks could be bigger.
The ECB has made clear that it’s focussing on core inflation, which shows little signs of life – oil prices have played an important role in even the pickup in German HICP. Indeed, the four necessary criteria which Draghi specfied for even starting to think about tapering QE seem some way from being met. These are that inflation needs to be: (i) near its goal “in the medium term”; (ii) durable, not transient (driven by oil prices); (iii) self sustained, not dependent on extraordinary ECB policy; and (iv) broad based – ‘”defined for the whole of the eurozone” not for individual countries. So an early QE tapering announcement seems unlikely. Indeed, The relatively-hawkish ECB GC member Nowotny recently argued that there’s no reason for the ECB to depart from the current stance, although they could discuss a reduction of QE in mid-2017. And ECB Mersch recently opined that the ECB should think about dropping reference to potentially even lower interest rates as a first policy innovation (see here) rather than QE tapering.
Concerns about the sustainability of the YCC policy rose after the BoJ susprisingly skipped a late-January purchase operation – causing 10-year JGB yields to spike to around 0.15% (versus 0.1% target), which the BoJ subsequently unwound via an unlimited ammount fixed-rate JGB purchase operation. Plus the BoJ summary of it’s 30-31 January meeting conceded that market concerns about YCC implementation are rising, given that the BoJ is set to own more than half of all JGBs by end 2018. And some market participants worry that Trump’s criticism of Japanese FX policy could morph into pressure on the BoJ. But recent BoJ commentart has re-affirmed their committment to YCC and local Japanese banks (the main sellers) reportedly hold around ¥220trn (12% of their balance sheets) in JGBs, slightly ameliorating supply concerns. But it was notable that there were no comments about BoJ policy at the recent Trump-Abe meeting.