Trumponomics signals sustained dollar rally
Strong dollar complicates policy-making in emerging markets
by George Hoguet in Boston
Wed 14 Dec 2016
Donald Trump’s proposed tax cuts risk further appreciation of the dollar and widening of the US current account deficit. These developments would complicate the president-elect’s efforts to stem manufacturing job losses and overwhelm initiatives to slow the offshoring of US factories. Tax cuts in 2017 should be accompanied by measures to reduce the federal budget deficit and promote private savings. Without these measures, there is substantial risk of a dollar overshoot reminiscent of the predicament during President Ronald Reagan’s administration.
Between 8 November and 9 December, the Federal Reserve’s trade-weighted broad dollar index rose by around 3.5%. The yen fell by 8.8%, and several emerging market currencies including the Mexican peso (minus 10%) and Turkish lira (minus 9.2%), sold off sharply.
Over the same period, the yield on US Treasury 10 year bonds increased by 61 basis points to 2.5%. Market participants significantly increased the probabilities of at least two more increases in the federal funds rate in 2017. The Federal Reserve is expected to make a start today, with a widely anticipated 25 basis points rise in the funds rate. The Russell 3000 Index, a broad representation of the US stock market, rallied 5.3%. Trump, through a combination of tax incentives and jawboning, convinced US air conditioning manufacturer Carrier Corporation not to relocate a plant to Mexico, thereby saving 800 Indiana manufacturing jobs. The president-elect has implied that he will intervene in similar ways in the future.
Analysis by the Tax Foundation suggests that Trump’s proposed tax cuts would lead to revenue losses between $260-390bn per year for the next 10 years. Whether Trump's tax cuts will be matched, as House Speaker Paul Ryan has advocated, by spending cuts, is anybody's guess. But market participants clearly believe that US aggregate demand and domestic corporate earnings will increase, the budget deficit will grow, and the economy will accelerate. With unemployment now down to 4.6%, the risks of unanticipated inflation and Fed rate hikes are increasing. In short, the prospect of expansionary fiscal policy and modestly contractionary monetary policy is laying the foundation for a sustained dollar rally. Continued weak recoveries and short-term negative yields in Europe and Japan are contributing to this phenomenon.
A strong dollar, leading to an increase in the trade deficit, could vex Trump’s trade and investment agendas. Studies suggest that a 10% increase in the dollar leads to an increase in the trade deficit by roughly 1% of GDP over 2-3 years. Dollar strength will further complicate dialogue with China, where foreign exchange reserves have fallen by nearly $1tn in the past 30 months and capital flight and renminbi support continues. A sharp deterioration in US-China relations could lead to a substantial devaluation of the renminbi, triggering a round of Asian currency depreciations. And, if history is a guide, the odds of emerging market debt crises increase as the Fed tightens and the dollar strengthens.
Theory and experience confirm that large US fiscal deficits lead to dollar strength. While evaluating its mix of economic policies, Trump’s administration should focus on raising the savings rate, reducing reliance on foreign savings and promoting vibrant exports and a stable dollar. If Trump fails to do so, the consequences will be significant.
George Hoguet is a Member of the OMFIF Advisory Board and Chair of CFA Society Boston.
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