The erratic Trump poses a great risk to the dollar

Outlook:

We can pr obably expect a slow day today as FX mar ket player s gir d their loins ahead of the ECB policy meeting tomorrow. The consensus has the bank extending the asset purchase program past the end-March ending date to at least Sept if not year-end-2017. The issue is what other adjustments are adopted. One idea is to widen the eligibility pool and to cut the amount from €80 to €60 billion per month. Any sign of "tapering" will be considered euro-positive. But there is some small chance that Mr. Draghi declines to name what the changes will be, if any. This, or an announcement that the program will be extended without any adjustments, will likely be euro-negative.
The WSJ reports that "Mr. Draghi could take a subtle approach to the tapering debate on Thursday. He could pledge, for instance, to regularly reassess the pace of bond purchases from the second half of next year. That way, the ECB chief could raise the possibility that purchases will slow later next year, without committing himself." But former BoI deputy Gov Gerlach says "For asset-purchase programs, a small modification risks leading to a devastating jolt to long yields and in bond prices, potentially triggering financial instability."

In short, we are waiting for an announcement effect. Announcement effects are far more powerful a mover in FX than mere economic data, proving the point that institutional factors outweigh fundamentals. We like to think—and history supports—that US politics have almost no effect on the level of the dollar. We have seen it repeatedly—impeach the president, the dollar stays flat. (Japan has had highlevel scandals and prime ministers resign, but the yen rolls on.)

But Brexit and Trump are changing the model. We need to take political risk into account far more than before. And nobody has raised political risk more than Trump.

The China-Taiwan story is not going away and has the potential to escalate into a financial problem. It emerges that not only was the telephone call a deliberate assault on US diplomatic policy, it was engineered by former Senator and presidential candidate Bob Dole or at least his lobbying firm. So much for Trump's claim he will drain the lobbying swamp. It's hard to say for sure quite how angry the Chinese are, but the China-Taiwan problem is a big burr under the horse-blanket and the horse can easily panic and bolt.

If Trump annoys the Chinese too much, he could lose whatever "deal" is needed to get China to help manage the bat-shit crazy North Koreans. He could also lose some portion of the $1.22 trillion in US Treasuries held by China (as of September). Insulting and agitating others could be bad for US yields. Japan has $1.15 trillion and Saudi Arabia, $96.5 billion. China and the Saudis have already been cutting their holdings, but an "incident" could all too easily trigger a Chinese divestiture announcement.

As a practical matter, the Chinese can't dump billions all at once, but that doesn't matter. What matters is the announcement effect. Trump boasts he is the consummate deal-maker but before you can make a deal, you need to bring the parties to the table. We have confidence Trump has more than met his match in the Chinese, who have rational plans to promote their self-interest and who can and will run circles around this clown.

The reserve divestiture fear has been around for many years and we have always dismissed it as not likely, for many reasons, including a shortage of other reserve-quality assets to substitute for Treasuries. But the Chinese are capable of thinking outside the box and inventing non-conventional reserve assets, including commodity stockpiles and non-reserve currencies. After all, the reason a country wants reserves in the first place is to be able to buy food or weapons on a moment's notice. A reserve currency is liquid and not questioned. But in practice, oil is liquid and not questioned, or rare earths, or lesser-but-liquid currencies like the AUD.

If Trump continues to poke the Chinese sore spot or worse, starts a trade war, the US economy will suffer. No one will suffer more than the blue-collar worker who voted for him. China will suffer, too. Exports to the US are 18% of total Chinese exports and amounted to $92.010 billion year-to-date in October. But China can control the workers whose jobs disappear in a trade war with the US. China can also devalue (again). Trade war retaliation by China would harm US sectors that include automakers, aircraft, and (somewhat weirdly) soybean farmers. Long run, the erratic and impulsive Trump poses a great risk to the dollar.

There's not much here so far but rising fear. Markets don't like uncertainty and US-China relations are a giant area of uncertainty that can only grow unless Trump starts doing things differently. Fat chance. Bloomberg reports that markets are still under-appreciating political risk. SocGen created the most worrisome chart (see below).

It shows global "credit spreads should be twice as wide given the current level of economic policy uncertainty." The global credit spread is calculated as "a weighted average of iBoxx U.S., euro, and U.K. corporate bond indexes relative to their respective benchmarks." In comparison, the "Economic Policy Uncertainty" index (EPU on the chart) is up at all-time highs, but spreads are at the median levels of the period going back to 2008." This may be a little fancy, but it doesn't look wrong. So, we have to ask, where is the safe-haven? We might say the yen and Swissie, as usual, but we also have to mention gold. Knee-jerk response, maybe, but history is chock-full of knee-jerk responses.