After a bout of US dollar strengthening in anticipation of President Trump’s promises to increase infrastructure spending, cut taxes and get America going, the dollar has in fact reversed and weakened against the Euro and the Japanese Yen.
What is going on?
It helps to remind us that whenever the dollar is strong, it tends to be bad for the rest of the world and good for the United States, because she can import goods and services mainly by printing more dollars.
The 1980s Latin American crisis, 1990s Asian financial crisis, and the 2007 subprime crisis all were associated with periods of strong dollar. In the long run, however, a strong dollar would worsen the US trade deficit and also her net foreign debt position ($8.1 trillion or 43.5 percent of 2016 gross domestic product), because her foreign assets decline in value as US foreign assets depreciate with local currencies, whereas the dollar liabilities remain fixed in dollars.
The bad news for emerging markets is that if the dollar appreciates, capital flows back to the US and the local currency is not only under pressure, it causes either higher interest rates, pressure to devalue the local currency or higher real value of US dollar debt. Thus, strong dollar signals slower rest of the world growth.
In reverse, a weaker dollar tends to be good for the rest of the world, which explains why even non-US financial markets are rallying.
There is an odd situation in the world today. Nearly 10 years after the 2007 subprime and European debt crises, long-term global interest rates are still significantly lower than real growth rates. With inflation currently still subdued, short-term interest rates are also low and even negative in some countries.
With the US economy beginning to recover and the unemployment rate continuing to fall, the US Fed has been reluctant to increase interest rates at a faster pace back a more normal path. The Fed is cautious because domestic politics has been unsettling, with no signs of agreement on either tax cut package or infrastructure spending. If it is seen to be aggressive in raising interest rates, then the dollar will continue to strengthen, creating even larger trade deficits and capital inflows.
Thus, the Fed seems willing to risk the return of inflation, because inflation would erode the real value of the current debt overhang, good for the American debtor, the largest being the Federal Government. Inflation is already being seen in the trend that producer price indices are now rising faster than consumer price inflation.
Of course, US interest rates cannot be independent of interest rates in the other major countries. So far, the Bank of Japan is very willing to continue quantitative easing and keeping interest rates near zero to get inflation back to the inflation target of 2 percent.
As long as the Italian and Greek banking problems are unresolved, the European Central Bank is keeping Euro interest rates low. However, with Germany running more than 8 percent of GDP current account surplus, and the whole Eurozone achieving an overall 3 percent of GDP current account surplus, the broad consensus is that Europe is finally ready to begin its recovery, with the Euro continuing to strengthen against the dollar.
Last week, when Trump appeared under siege politically after the firing of FBI director Comey, the markets reversed from its recent heights and the dollar weakened. The issue is whether the Trump stock market rally has peaked?
The fortunes of the dollar have significant impact on the course of the RMB. After nearly 18 months of continuous downward pressure on the RMB due to capital outflows, the People’s Bank has managed to contain the loss of foreign exchange reserves and maintained the stability in the RMB against the dollar. But the loss of nearly $1 trillion in foreign exchange reserves has tightened domestic liquidity and domestic interest rates have edged upward. This is exactly what one would expect as outflows cause loss of RMB deposits in exchange for foreign currency.
The central bank therefore needs to provide continuous funding to ensure that the domestic liquidity situation does not create a credit crunch. The central bank needs to maintain a tight monetary stance, because excess liquidity flows out and hurts foreign exchange reserves. Too little liquidity risks credit defaults. Getting the balance right is more an art than a science.
Looking at the current situation, we have financial markets at record peaks in almost all the major markets, even though growth has not fully recovered to pre-crisis levels, whilst global debt levels are at record highs.
In the meantime, geopolitical tensions are of the gravest of concerns. A recent Bloomberg survey showed that half of over 400 investment professionals indicated that geopolitics is the greatest uncertainty in the investment horizon, with 47 percent worried about Trump policies and 38 percent concerned about Brexit. Only 3 percent was worried about China’s growth outlook and policy landscape.
The continued froth in technology stocks and punting of financial stocks recovery with higher interest rates mask the general decline in traditional industries’ share prices. Despite record prices in US equities, 40 percent of fund managers want to invest in the US, 28 percent in Southeast Asia and only 10 percent in Europe. Thus, the medium term upside for the US dollar is still intact, provided that the Trump Administration is able to demonstrate that it can steer the economy to higher grounds without political gridlock.
Betting on the US dollar strengthening is today a mix of classic greed and fear. The US still offers good upside potential, despite record equity peaks and low interest rates, but there is always the fear that Trump politics will change the game with the next tweet. Betting on news through the PredictiT website (using betting odds to predict political events) is already suggesting that there is a one in five chance that Trump may be impeached in 2017.
No investor today is immune to the Trump effect -- a Rally or a Dump. Either will be scary.
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By Andrew Sheng
Andrew Sheng is Distinguished Fellow, Asia Global Institute, University of Hong Kong. -- Ed.
(Asia News Network)