Everybody is overlooking the obvious when it comes to the dollar under the Trump administration

The US dollar is likely to benefit from pull factors in 2017 of yield and stability, according to analysts

PUBLISHED : Tuesday, 20 December, 2016, 10:33am
UPDATED : Tuesday, 20 December, 2016, 10:57pm

The Federal Reserve may have increased interest rates last week but there is a very real risk that the US central bank ends up having to raise them significantly further than it currently envisages. If the Fed does end up initiating a wave of further and faster rate hikes, the ripples will undoubtedly be felt in China and Hong Kong.

The Fed doesn’t yet seem to have factored in that Donald Trump will be President and that he means business.

That’s not to decry what the Fed actually did last week. The US central bank raised its target rate by 0.25 per cent as markets had expected. It also signalled that it now expects to increase rates three times next year as opposed to the two hikes it had mooted just a few months ago.

While a more forthright tone from the Federal Reserve surprised analysts at Japan’s Bank of Tokyo-Mitsubishi UFJ (BTMU), the firm was also quick to note that “the Fed has not yet adjusted its economic outlook to incorporate the potential stimulative impact of looser fiscal policy under President-elect Donald Trump.”

“The Fed still expects economic growth to remain moderate in the coming years expanding by around 2 per cent which it expects to help lift inflation gradually back towards the long-term goal,” BTMU wrote but that seems to take little or no account of Trump’s fiscal plans.

“Therefore, if President-elect Donald Trump follows through with looser fiscal policy it will prompt the Fed to lift their forecasts for growth and inflation justifying an even faster pace of rate hikes in the coming years than the six currently planned by the end of 2018,” the Japanese bank concluded.

Stephen Li Jen at London-based Eurizon SLJ Macro already takes the view that “for much of [the first half of] 2017, the market’s interpretation of the willingness of the Trump Administration to do what they said they would do could be more important than the question of whether the Trump Administration would be successful.”

The Federal Reserve might be cautious about factoring in the impact of Trump’s policies into its view of the pace of US economic growth, but bond traders may not be so shy. US Treasuries may again fall in price and yields rise.

Jen likens the Fed “to a nurse trying to inoculate a child, but struggling to do so” for fear of hurting the infant “even though the inoculation shot is necessary. Well, after manufacturing all sorts of excuses to procrastinate, the child is now a teenager, not scared of the inoculation shot.”

Indeed Jen believes that “if anything, the teenager now realises that he should have gotten multiple shots by this age, and wonders if the nurse knows what (s)he is doing,” he wrote.

That said, on December 14 Fed Chair Janet Yellen said that “fiscal policy is not obviously needed to provide stimulus to help us get back to full employment.”

Markets might well infer from such a statement that if the Trump administration does follow through on its fiscal stimulus plans, then the pace of Fed hikes will pick up. If so, the market will not wait around. The Fed will be left to play catch up.

In Hong Kong, given the long-standing currency board mechanism, the HKMA would be left having to move in step with the Fed just as it did last week

As for the yuan, if the Fed is behind the curve and ends up having to raise rates higher than it might have expected to do, then that may merely encourage more capital to flow out of China resulting in a weaker value for the yuan.

Eurizon SLJ Macro feels 2017 will see the yuan “under mounting pressure,” arguing that “thus far, most of the motivations for capital outflows are ‘push’ factors, i.e., China-specific factors. Going forward, there will be strong ‘pull’ factors as the US offers attractive yields and stability.”

HSBC’s Global Head of Foreign Exchange Research David Bloom thinks the dollar is going to rise further against emerging market currencies whether Trump’s policies prove inflationary or even if they fail.

“I don’t care whether it’s Trump-flation or Trump failure. If it is Trump failure the dollar’s going up against emerging markets, if it’s Trump-flation the dollar’s going up against everything,” Bloom said recently.

When it comes to spending, Donald Trump means business. The sooner the Fed accepts that, the better. Otherwise there’s a real risk that both US interest rates and the dollar overshoot on the topside, dealing the yuan a crushing blow in the process.