Why the Trump effect matters for investors betting on a strong US dollar

Andrew Sheng says with the world’s economic fortunes spinning on the US dollar and fund managers most wary of geopolitical uncertainties, a Donald Trump tweet may be all it takes to change the game

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US President Donald Trump and Japanese Prime Minister Shinzo Abe seen on a TV monitor as the one next to it shows the yen’s exchange rate against the US dollar, at a forex trading company in Tokyo on February 1. Photo: Reuters

Published: 9:39am, 26 May 2017Updated: 6:56pm, 26 May 2017

After a bout of strengthening on President Donald Trump’s promises to boost infrastructure spending, cut taxes and get America going, the US dollar has reversed and weakened against the euro and yen.

A strong dollar tends to be bad for the world and good for the US, because it can import goods and services mainly by printing more money. The 1980s Latin American crisis, 1990s Asian financial crisis, and the 2007 subprime crisis were all associated with a strong dollar. But, in the long run, a strong dollar would worsen the US trade deficit and also its net foreign debt position, because its foreign assets decline in value, depreciating with local currencies, whereas dollar liabilities remain fixed in dollars.

The bad news for emerging markets is that if the dollar rises, capital flows back to the US and the local currency is not only under pressure, it also causes higher either interest rates, pressure to devalue the local currency, or higher real value of US dollar debt.

A strong dollar signals slower growth for the rest of the world

Thus, a strong dollar signals slower growth for the rest of the world; or, a weaker dollar tends to be good for the rest of the world, which explains why even non-US financial markets are rallying.

The world faces an odd situation today. Nearly 10 years after the subprime and European debt crises, long-term global interest rates are still significantly lower than real growth rates. With inflation currently still subdued, short-term interest rates are also low and even negative in some countries.

With the economy starting to recover and the jobless rate still falling, the Federal Reserve has been reluctant to raise rates at a faster pace. It is cautious because domestic politics has been unsettling, with no agreement on either tax cuts or infrastructure spending. If it is seen to be aggressive in raising interest rates, the dollar will keep gaining, creating even larger trade deficits and capital inflows.

US Federal Reserve chair Janet Yellen and Mario Draghi, president of the European Central Bank, at the IMF/World Bank Spring Meeting in Washington in April, 2014. Neither is in a hurry to raise interest rates. Photo: Reuters

Thus, the Fed seems willing to risk the return of inflation, as that would erode the real value of the current debt overhang, which is good for the American debtor – the largest being the US government. Inflation is already being seen in the trend that producer price indices are now rising faster than consumer price inflation.