Bond and equity markets have (so far) brushed off the political dramas unfolding in Washington. For the U.S. dollar, on the other hand, it’s a different story. Since the beginning of this year, the trade-weighted dollar has dropped around 10%. For an administration that said that “Our companies can’t compete with them [Chinese companies] now because our currency is too strong. And it’s killing us,” the dollar weakness should be good news. But if it reflects a lack of confidence in the government, that is bad news.
Policy developments – or lack thereof – have been negative for the dollar with sensational headlines and drama adding to fears of general Washington dysfunction. Last week’s failed attempt at healthcare reform yet again, highlights the fact that there has been no progress on the much-promised tax reform and infrastructure spending plans. Undoubtedly, the fading prospects for meaningful tax changes and fiscal stimulus, as well as growing concerns about the looming debt ceiling impasse, are taking a toll on the U.S. dollar.
Of course, there is more to the decline in the dollar than just the White House’s revolving door and lack of policy success. The fall in inflation has also weighed on the greenback as expectations of monetary policy tightening have fallen. The market is pricing in just one more 25 basis point rate hike over the next 12 months, and just a 45% chance that the U.S. Federal Reserve (Fed) will raise rates again this year at all. Only a few months ago, there was speculation that there could be two more rate increases in the second half of this year alone.
At the same time as the outlook for Fed policy has become more dovish, the Bank of Canada has become more hawkish, and the European Central Bank (ECB) continues to gear up for tapering early next year.
In fact, the U.S. dollar has been hit particularly hard by brightening economic prospects in the euro area. While U.S. growth momentum appears to have peaked, it is strengthening in the euro area. And while U.S. political risks are escalating, President Macron’s resounding victory in France greatly diminished political fears in Europe. Even without the Washington disorder the dollar would have struggled to strengthen against the euro, and I doubt the downward trend will be broken during the remainder of this year.
Looking further out, there are a few factors that could put a floor under the dollar. I’m hopeful that inflation will eventually pick up given the tightness of the labor market and that should raise market expectations for Fed policy tightening. The Fed is also likely to start balance sheet reduction in the near future, while the ECB’s balance sheet will still be expanding, albeit at a slower pace. The first mover advantage means that U.S. assets could be relatively more attractive for a time, putting upward pressure on the U.S. dollar. And when it comes to politics, the 2018 midterm elections mean that, on the legislative front, the administration will be urgently seeking to push something, anything, through Congress.
For the time being, investors can benefit from U.S. dollar weakness by looking at emerging market debt and equities. I’ll write about this in more depth in the coming weeks, but if you’re interested, you can read my latest Strategic Relative Value, which provides a quarterly look at how I expect macro and market events to drive relative value around the globe, including in emerging markets.
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