Barring those who have been living under a rock over the last couple of months, traders may have noticed the meteoric rise in the US Dollar since the end of September. The Yen, the Mexican Peso and the Euro in particular have been getting hammered, the latter even threatening to reach parity with the USD. So why is this happening?
“Trump” is the first thing that will come to the minds of many, and certainly explains part of what is going on, but there are other factors at play here.
The Dollar had in fact been falling consistently since June, losing over 5% on the DXY before undergoing a violent reversal at the end of September. A major reason for this decline was simple interest rate positioning. Markets were expecting the Fed to rapidly lower interest rates on the Dollar due to a number of worrying economic data points earlier in the year. Gradually, markets realised these points were overplayed and rate cuts were not that necessary after all. The Fed has indeed been remarkably careful in lowering rates so far this year. Essentially, the Dollar was severely oversold.
Eventually, the pendulum peaked and began to swing back. It just so happened that this coincided with a growing sentiment that a Trump presidency was once again on the cards. Betting markets painted a much clearer picture than the polls this year and it turns out they were right on the money.
At this point, let us remind ourselves that the Euro makes up the majority of the DXY weighting, 57% in fact. So what is going on in Europe?
The problems in the US economy may indeed have been overstated, but the same cannot be said for the European economy. First of all, Germany and France, the Eurozone’s largest contributors, continue to exhibit poor manufacturing figures as well as non-existent investor confidence. The European Central Bank is now on the difficult path of having to reduce interest rates in an effort to stimulate growth, on a currency that has already devalued significantly in recent months. On the other side of the Atlantic, the Fed is under no such pressure to reduce rates as quickly, having a lot more room to manoeuvre within a more robust economy.
Rates on the Dollar are currently 4.75%, whereas the ECB has cut rates on the Euro down to 3.4%. Not a huge difference, but it is looking increasingly likely that this gap will widen as opposed to narrow. A growing interest rate differential will only put more pressure on the common currency, further devaluing the Euro and bolstering the Dollar.
With that out of the way, what about President Donald Trump? Why would a Trump presidency strengthen the Dollar? In a nutshell: protectionism. Protectionist policies will increase tariffs on imported goods, which will likely reduce the amount of goods imported into the US, which affects the trade balance. Currently, the US has a trade deficit of about $80 billion. If the proposed measures are enough to shift this into a trade surplus, this will increase demand for the Greenback as the rest of the world needs the Dollar to pay for US products. Tariffs on foreign goods would also make domestic products more attractive, further favouring American businesses and the US economy in general.
A minor caveat is that protectionist policies over a long enough time-frame can result in higher prices, potentially leading to inflation, which would devalue the Dollar. A much larger caveat lies in how other nations are likely to respond to additional tariffs, potentially leading to trade wars. What’s next for the Dollar? President Trump will inherit a very different economy from the one he got in 2017, so looking at historical data can only be so enlightening. The response of the likes of Europe, Mexico and China are equally difficult to predict. The Euro has only dipped below parity once since 2002 and even then it only stayed there for a couple of months. Place your bets.
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