- Expectations of tariffs and tax cuts have fuelled a frenzy of USD and US stocks buying.
- Markets have also begun scaling back rate cut expectations, pushing the dollar higher.
- But for the medium term, views on inflation, fiscal, equity markets, and geopolitics are material.
- Asset price crash and financial instability next year could be dollar negative.
- If tariffs bring down US imports, exporters will have less USD to buy treasuries, a USD negative.
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Commentary: Trade war and USD
There is a near-term and a medium-term scenario for the US dollar. The near-term one came into play vigorously with Donald Trump’s election on November 5. Trump trades are on full swing presently, with soaring cryptos, equities, and USD, while the fixed income market has sold off. These trades are pricing in policy support for the cryptos, tax cuts, tariffs, and fiscal expansion. Speculation around the US dollar has been changing since the September Fed meeting, but a decisive return of dollar bulls has materialised only in recent days.
It’s not all about Trump. The markets have begun questioning the Fed’s desire and ability to cut rates. Even without Trump’s policies, latest data point to (i) an economy growing robustly, tracking 2.5% growth, (ii) moderate inflation dynamic, but still way higher than the Fed’s 2% target, and (iii) still-strong labour market, with high employment and positive real wage growth. These point to little urgency for accommodation, giving the Fed the room to wait and see how far it needs to go with rate cuts in the coming months. As expectations coalesce around a higher terminal rate in this cycle, that is fodder for dollar bulls.
Past the euphoria of Trump trades, however, a more challenging outlook awaits the dollar. Nominal interest rate differentials are not the only factors driving the dollar, medium term views on inflation, government bond issuance, equity markets, and geopolitics are also material. Considering these, we look at some reasons to be a medium-term dollar bear.
The dollar could come under pressure if there is an asset market crash and/or if treasury issuance balloons, reducing the attractiveness of US assets. Under such a scenario, Fed policy rates may have to come down even if the battle against inflation is not fully over, which would be a clear negative for the dollar.
Additionally, weaponisation of the dollar in recent years has given global central bankers and treasuries the motivation to look for alternative assets on the margin, while the private sector has turned increasingly enthusiastic about cryptos and gold. An assertive Trump administration on a variety of matters of geopolitics could add further fuel to this dynamic.
Finally, the matter of US twin deficits. In recent years, US fiscal deficit has been running at 5-6% of GDP. A third of the US treasuries issued to finance these deficits are purchased by foreign buyers, whose supply of dollars comes from the counterpart of US current account deficit, which has been running at 2-3% of GDP lately. Now, if Trump’s tariffs succeed in compressing imports, lowering the trade and current account deficits, there will be less dollars for the rest of the world to recycle. Dollar’s outlook would be suspect in that scenario, in our view.
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