The Trump dollar slump and asset price bump: What the US dollar means for assets going forward
October 26, 2017
The past year has been full of hope and despair for the US dollar. The election of President Trump brought hopefulness — the US dollar rallied on odds of greater dollar repatriation of offshore corporate profits, potentially favorable trading terms for the United States (albeit amid fears of draconian measures toward other countries), and the possibility of stronger US growth from economic and tax reforms. Equities rallied along with the dollar on the chance of these reforms pushing growth higher. Further, it was thought that this growth would lift inflation. US Treasury yields rose, driven by the same vein of optimism.
Fast forward nearly a year since the election, and we are well off the highs in the US dollar. Globally, however, asset prices have continued to rally for various reasons. As the political backdrop in the US became more and more caustic, hopes for reform faded, and with that, the chances for higher US growth and inflation. As a result, Treasury rates fell and inflation remained soft, but global growth was strong enough to exert even greater downward pressure on the US dollar through perceived growth differentials between that of the rest of the world and the US. This was more based on perceptions of US “economic exceptionalism” fading than it was based on true growth differentials. Put another way, more good things were priced into US growth, and consequently the US dollar, leaving the dollar vulnerable.
This pressure on the US dollar was further accelerated by more hawkish behavior by other central banks while expectations for more aggressive rate hikes from the US Federal Reserve waned, not only on somewhat lackluster inflation but on diminished fiscal hopes. Meanwhile, investors have been remarkably bullish on emerging markets (EM), emerging markets foreign exchange (EMFX), and carry trades as confidence in US economic exceptionalism has diminished, keeping rates in the US low, while fears of an all-out protectionist trade war subsided.
Turmoil in DC provides air cover
We would argue that the problems in Washington, DC, have provided a cover for asset prices to continue to climb through US dollar weakness. This weak dollar support has seemed most strong for EM and EMFX assets. All told, the US dollar has engaged in a feedback loop that has benefited asset prices globally year to date. In some ways, President Trump and Washington have given the globe a liquidity injection — or a “Trump rate cut” — through US dollar weakness. Thus the Trump dollar slump has helped support this asset price bump. The question now is: How do we see things evolving for the US dollar, and will the dollar be a major influence on other asset prices in the near term?
How the US dollar can drive cycles
First, a bit of technical background on the types of feedback loops a weaker US dollar can help precipitate. In a broad sense, these cycles represent how the Trump dollar slump served to benefit asset prices, albeit in a highly stylized way. In the past, we have argued that a strong US dollar represented risks to the global environment. Those problems have played out to a degree, but now we are experiencing some of the virtuous cycle a weaker US dollar might represent.
A bit of caution is warranted: If the US dollar is weak for the right reasons, it can be good for the globe, as we’ve seen over the course of 2017. If the US dollar is weak because US growth is falling considerably or there are fundamental problems in the US economy, this is less favorable for risk assets such as emerging markets, because the perception that "if the US catches an economic cold, emerging markets get the flu" still rings true in practice. The benign weak dollar scenario for global growth is certainly what we are witnessing at present, as the weak dollar is being driven more by stronger global growth and repricing of foreign central banks’ rate paths relative to the US (see graphic). However, reversing that logic, as we move forward in time, would a stronger dollar based on policy success in Washington pose a risk to asset prices? We believe it could.
US dollar weakness creates more reasons to love carry and compression
While we think it’s unlikely that the US political backdrop would significantly improve over the coming quarter, the chances of tax reform happening are, we believe, higher than market expectations — which remain exceptionally subdued. We expect the US dollar to correct higher on the hope of tax reform, which in turn would likely pressure asset prices to a degree. This may be more notable in EMFX and local markets rather than other asset markets.
Overall, we might expect a subdued dollar rally that could derail EM assets for the time being. In our view, a sustainable US dollar rally is less likely given the uptick in growth elsewhere around the globe. However, if the growth profile outside of the US weakens substantially, and the US enacts major tax reform, including favorable rules for repatriation, we may see a more sustainable US dollar rally.
Ultimately — and this has been the catch with a strong US dollar — if global growth is too soft and the US dollar is too strong, causing risk aversion and asset price sell-offs, we may find ourselves with a more dovish Fed, and consequently, back on track for a weaker US dollar. Fed policy, and thus the US dollar, will remain inexorably linked to global economic and asset price stability.
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Currency risk is the risk that fluctuations in exchange rates between the US dollar and foreign currencies and between various foreign currencies may cause the value of an investment to decline. The market for some (or all) currencies may from time to time have low trading volume and become illiquid, which may prevent a fund from effecting positions or from promptly liquidating unfavorable positions in such markets, thus subjecting the fund to substantial losses.
The views expressed represent the Manager's assessment of the market environment as of October 2017, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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