FX market did not respond to the US government shutdown

Outlook:

The FX market did not respond to the government shut-down in any meaningful way. In fact, it went up a little on the shutdown and down a little on the shutdown ending, which is backwards. What does it mean? Nothing much, except maybe that confidence in the US econo-my is so strong that it overrides whatever the government is doing. As El-Erian wrote yesterday, a gov-ernment shut-down doesn’t affect company earnings and the stock market can barrel merrily along. And we have seen increased or decreased bond issuance barely make a dent in the FX market, nor deficits or debt ratios.

So if the dollar is independent of these things, why is it down over 10% last year and 2% so far this year and January not even over yet?

The now-standard explanation is that the UK is going to weather Brexit better than we thought, the eu-rozone is on fire and the ECB will act, and even Japan may begin tapering this year. Divergence is over. Now we have convergence. The US may have been the leader in normalization, but others engag-ing in normalization are more interesting, exciting and likely profitable.

Another idea is that Trump is the death-knell of the dollar as top reserve currency. The loss of trust in the US government is a Big Deal. The world has been trending toward reserve diversification for a very long time, and Trump is the tipping point. The threat is not immediate or obvious, as in the case of France and Germany adding the Chinese currency to reserves in a tiny amount, but it’s a genuine threat.

John Plender in the FT writes that what’s “striking about the longer-term [dollar down] trend is how little interest rate differentials have had to do with it. Since last summer widening interest differentials between the US and other advanced economies have failed to underpin the dollar. In effect, leading currencies have not been responding to the supposed laws of international finance. Hence growing speculation that a structural shift may be under way whereby Trump’s dollar is losing its status as the pre-eminent global reserve currency.”

The RBA estimates non-traditional reserve currencies are now 7% of the total, from 2% in 2009. The CAD and AUD are increasingly in the mix. Central banks are seeking yield as much as diversification, so if we consider the zero or negative yields on euro assets that is going to end in the next year or two, the dollar may go down on that alone. Or not, as US yields continue to rise.

We can buy both stories, but both narratives are slow-motion. History teaches us that big market moves come with Event Shocks. And there is a gigantic Shock sitting around the next corner--what Trump does next on trade. Dread is the right descriptor. After the Wall with Mexico, changing the US’ trade profile was the other big Trump campaign promises. And we are on the threshold of finding out how that is going to look. It’s a terrifying prospect.

The White House imposed tariffs on solar panels (a long-standing thorn in the side) and washing ma-chines, seemingly targeting China and South Korea. The WSJ reports this is the beginning of America First trade skirmishes, if not wars. “That suggests the political fallout from trade deficits could get more severe. Nominally, deficits were much higher a decade ago. But strip out petroleum—a commodi-ty the U.S. now produces in abundance—and adjust for inflation and the trade gap hit a new high in November, a reflection of America’s strong appetite for foreign goods and the ability of other nations to supply them.”

Trump will make a speech on trade at Davos on Friday. The WSJ offers a stunning chart. See the enxt page.

Then there’s NAFTA. This is a confusing story, with the erratic Trump one day saying talks are going well and he will wait until after the Mexican election on July 1 (unilaterally breaking the current dead-line of March 1), but other days featuring stories about how badly the talk are really going and Canada in a state of despair. Any time you think you see a nice trend in the CAD or peso, watch out. The WSJ notes that the peso tends to drop almost 6% ahead of Mexican elections since 1994.

Pin this chart to your monitor. We are going to see it repeatedly over the next three years. It’s just about the only thing “real” about curcus ringmaster Trump.

On another front, ex-Richmond Fed Goodfriend is up for an empty Fed Board seat and will not face any problems obtaining Congressional confirmation. One analyst notes Goodfriend is a critic of QE as inviting inflation, despite all the evidence that it did not do any such thing. He may favor the Taylor Rule, which would have the Fed funds rate at over 4% instead of 1.5% today. We have been dismissing the new Fed board composition as not likely to introduce much change, or much change at a noticeable speed, but perhaps that confidence is misplaced.

We can expect some gyrations, especially in the euro as the ECB meeting approaches, but on the whole, normalizing positioning from a too-short dollar level suggests a bump up in the dollar while the Big Picture suggests staying short is the wise course, given who’s in charge.

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