Akash Prakash: Determining the dollar in Trump's America

Watch for early clues on the extent to which the US President will go to cap the currency's rise

Probably the biggest decision for investors in 2017 is determining the direction of the US dollar. Even more than getting your call on interest rates right, predicting the direction and trajectory of the dollar will be critical for asset allocation. Entering the year, the currency had already risen by almost 25 per cent over the past 30 months. Would it keep appreciating, thereby pressurising Emerging-Market (EM) assets, commodities and precious metals. Or will the long rally come to an end, lifting pressure on EM assets and commodities? Is there really an effective $10 trillion short as BIS implied a few years ago? Will a further rise in the dollar trigger an EM crisis as highly leveraged corporates can’t meet their payments, or will a decline in the currency trigger an EM bull market? The outlook is hazy at best, and strong arguments can be made on both sides.

For the dollar bulls, the case for a strong currency is quite straightforward. Interest rates in the US are rising,with the positive carry on US debt assets only increasing. The Federal Reserve (Fed) is on a path of increasing rates, divergent from the Quantitative Easing (QE)-forever outlook of the European Central Bank and Bank of Japan. With Donald Trump signaling his desire for fiscal expansion combined with tax cuts, most experts are convinced that the direction in rates is only up. While the Fed has been slow and deliberate in raising rates till now, many feel we may see them now accelerate and over-deliver on rates. Janet Yellen has clearly no intention to be seen as being behind the curve. 

There is also a possibility of a continued improvement of the US trade balance through higher domestic shale production. Falling trade deficits should be positive for the dollar at least in the short term. 

Some of the changes being proposed by the republicans for the tax code may also cause currency appreciation. The proposed border tax adjustment should itself force the currency to move upward, as both importers and exporters adjust prices to factor in tax changes. 

All of the above should argue for a pretty clear case for continued dollar strength.

On the bearish side, almost everyone is bullish on the dollar. It is a consensus trade. Also given the outperformance of dollar assets over the past few years, everyone has structurally overweighed the currency in their portfolios.

Trump is a mercantilist, favouring protectionism. There is very little ambiguity about his position on trade after the inauguration. A mercantilist is very unlikely to support a strong dollar. A weak currency is often the foundation of their economic strategy. Trump has already publicly complained in an interview to the The Wall Street Journal about the strength of the dollar. This is a very unusual position for a US President to take. 

The dollar is also overvalued against almost every other currency using the purchasing power parity metric. The deviation is between 1 and 2.5 standard deviation from the long-term mean.

Most investors seem to be convinced that the dollar will continue to strengthen. Either they believe that Trumpflation will drive the currency higher or if the new President were to trigger a trade war with China, break up the North American Free Trade Agreement, and other stupid policies, a spike in risk aversion will in any case push the dollar higher. This seems like an easy bet to make, in almost any scenario the dollar will rise.

Illustration by Ajay Mohanty

It is, however, equally clear that if Trump is serious about reviving manufacturing in the US, he cannot afford to let the currency strengthen further. It is already hurting corporate America, both earnings and competitiveness. Remember it is the rust-belt states in Midwestern US that brought Trump to the White House. This constituency wants a revival in investments and high-skill jobs. They want to “Make in America”. A strong and overvalued dollar is unlikely to achieve Trump’s vision of “making America great again”.

Is there anything that the new President can do to make sure the dollar rally is short circuited? 

He can lean on the Fed to delay its rate rises. The market currently expects three rate rises in 2017. The Fed has consistently delivered less rate hikes than consensus expectations over the past few years. If this pattern were to repeat in 2017, it would release some pressure on the currency.

There is also a possibility that economic data in both EU and Japan are better-then-expected on growth and inflation. The consensus view that QE will continue forever in both economies may be unfounded. Already the data is better than the consensus over the past few weeks. Normalisation of monetary policy may be faster than investors anticipate, and the divergence in monetary outlook less severe.

The reality is that markets are positioned one way, very confident and complacent that the dollar is only going up. The reality is that the Trump administration is almost certainly in favour of a weaker currency. If the dollar were to weaken, we may see a significant move upwards in EM assets and cyclicals. The biggest concern holding back investors in these asset classes is the fear over a strengthening currency. The surprise of 2017 may well be that the dollar stalls and we see a surge in EM assets. In such a scenario, global asset allocators do not own enough of EM assets. Any upward move will lead to performance chasing, which can easily swamp the asset class. Watch for early clues on the extent to which Trump will go to cap the dollar rise. It may decide who wins this debate.  
 

The writer is at Amansa Capital. These views are his own