Strategy: The danger of the consensus view

Since the Donald Trump US presidential election victory, a strong consensus has formed that the USD will strengthen substantially and that US rates will head a lot higher. The story goes that Trump-led fiscal stimulus will drive a higher US neutral rate and a stronger USD – much like during the first Ronald Reagan administration in 1981-84. Near term, we agree – rising US growth expectations will drive a stronger USD and higher global rates.

As we have pointed out recently (see Strategy: The case for reflation – what it means and what to watch, 18 November), the US economy was already gaining speed before the Trump victory. Over the past few weeks, euro area October retail sales, Germany factory orders and China PMI Manufacturing have all surprised substantially on the upside, suggesting that the US-led recovery is spreading to Europe. However, for us, the view of a stronger USD is a short-term one and there is a high risk that the push higher in global yields will lose steam. For a start, there is a lot of uncertainty about the type of US fiscal stimulus and how quickly it will filter through to the economy.

For example, the infrastructure spending that Trump has been advocating will not be financed by the federal government but rather by a ‘deficit-neutral system of infrastructure credits'. There is no guarantee that Congress will agree to the tax credits or that business will respond as intended. In addition, Trump's tax cuts will tend to benefit the ‘better off', who have a lower propensity to consume and hence a lower fiscal multiplier (see Table 1). Finally, the output gap in the US is largely closed, which suggests that fiscal stimulus will be more inflationary than growth boosting and there may be a negative growth impact beyond a year (see Table 2 overleaf). As such, there is a substantial risk that at some point during 2017 the market will be disappointed with US growth prospects. From a USD perspective, Trump/Janet Yellen are very different from how Reagan/Paul Volker were during the early 1980s, when significant fiscal stimulus was combined with a much more hawkish outlook, driving a rapid increase in real interest rates (see Chart 1 and Chart 2). Indeed, we see the risks skewed towards the Fed lowering its long-term neutral rate at next week's meeting. In our view, the FOMC will shift in a more dovish direction in 2017 due to the change in voting rights, even taking into account that Trump may appoint hawkish governors for the two vacant seats. We note that the Fed's trade-weighted dollar has reached the strongest level since 2002. If the USD becomes too strong, the Fed will turn dovish exactly as it did early this year. Hence, Trump's policies should lead to higher inflation and higher inflation expectations and lower US real interest rates. This is exactly the opposite of the Reagan/Volcker period and is not USD bullish – quite the opposite. Lower real interest rates should lead over time to a weaker USD – not a stronger one.

Meanwhile, it is becoming increasingly costly to be bearish on US FI if you do not get the timing right. For example, the 10Y UST yield is around 2.44%. Taking into account the carry and roll-down, the 10Y UST yield will need to be above 2.70% in 12 months for investors to make money being short 10Y UST now. We need only remind ourselves about what happened in 2014 when the USD rallied strongly. At end-2013, most observers were expecting a sharp increase in US rates but instead the 10Y UST yield fell to 2.17% at end- 2014, from 3.03% at end-2013. For 2017, it is difficult to imagine both that the USD will rally sharply and that US rates will head a lot higher. Something has to give. In our view, the USD will be first to give, when we expect dollar strength in late 2016 to early 2017 to give way to a broadly weaker greenback later in the year.

 

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