US Dollar tugged one way by Trump, the other way by the Fed - Natixis

Nordine NAAM, Research Analyst at Natixis, notes that the since the start of the year, the US dollar has undergone a sharp correction against most G10 currencies and emerging currencies.

Key Quotes

“As a result, the DXY dollar index is down more than 3.5% from the 103.8 high set at the start of 2017, with the index currently testing 100. The dollar’s bout of weakness is due mainly to uncertainties over Donald Trump’s economic programme. The new president has maintained radio-silence when it comes to his fiscal stimulus plan, with few references in his latest speeches and recent tweets, which has rattled the equity markets, as they rose sharply Q4 2016 in anticipation of a substantial fiscal stimulus plan.”

“The new president made it clear he was unhappy with the strength of the US dollar, saying “our currency is too strong, and it’s killing us”. Finally, Donald Trump signed an executive order ending the participation of the US in the Trans-Pacific Partnership (TPP) to which 12 Asian Pacific countries are party, and he is seeking to renegotiate the North American Free Trade Agreement between the US, Canada and Mexico. Clearly, protectionism and isolationism are the order of the day in the US.”

“Under these conditions, what is the outlook for the US dollar? Is it really overvalued? Is the US about to engage in a currency war? We think not. As measured by its real effective exchange rate (RERR), the US dollar is above its 20-year average, but not by as much as in the 2000s. Furthermore, the current account deficit is not that negative at 2.6% of GDP in 2016 (reflecting the dollar’s status an international reserve currency). Finally, the level of the US dollar does not have a huge impact on the US economy, as exports account for only 12% of GDP.”

“Despite the negative news flow, the US dollar has not caved in. The reason is that there have been some hawkish statements on the part of FOMC members and that the solid macros indicators out of the US confirm growth remains solid. The US economic surprise index stands at historically high levels, while financial conditions remain accommodating. The economy has reached full employment and inflation is expected to near 3% this year. In this respect, Fed Chair Janet Yellen reiterated that the US economy was sufficiently solid to absorb the rise in the Fed Funds rate and that the Federal Reserve needed to restore some leeway. Our scenario is for three interest rate hikes this year, which can be expected to fuel a further widening of the spread between the US 2-year rate and the G10 2-year rate (average rate for G10 countries without the US).”

“In this context, the US dollar will be tugged higher by heightened expectations of a monetary tightening and tugged lower by Donald Trump’s protectionist rhetoric. In the short term, the greenback will remain downbeat in the absence of announcements concerning the fiscal stimulus programme. It is likely that volatility in the foreign exchange market will remain on high.”

“The US dollar’s recovery is likely to kick in only when Donald Trump mentions his fiscal stimulus programme. It is not certain there will be a State of the Union Address before Congress in February, when the president generally sets out his economic programme. Over the medium term, however, the US dollar will remain upbeat, bolstered by the tightening of monetary policy and the solid US economic growth. In other words, Donald Trump will not be able to check the dollar’s appreciation, simply slow this ascent. Therefore, we see the EUR/USD correcting towards parity over coming months.”