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

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.

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.

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.

Of course, US interest rates cannot be independent of rates in other major economies. So far, the Bank of Japan has been keen to continue its quantitative easing and keeping interest rates near zero to get inflation back to the target of 2 per cent. As long as Italian and Greek banking problems remain unresolved, the European Central Bank is keeping euro interest rates low. But with Germany running a current account surplus of over 8 per cent of GDP , with the overall euro zone figure at 3 per cent of GDP, the broad consensus is that Europe is finally beginning its recovery, with the euro continuing to strengthen against the dollar.

Earlier this month, when Trump appeared politically under siege after his firing of FBI director James Comey, the markets reversed from recent heights and the dollar weakened. The issue is whether the Trump stock market rally has peaked.

The fortunes of the dollar have a significant impact on the course of the renminbi. After nearly 18 months of downward pressure due to capital outflows, the People’s Bank of China has managed to contain the loss of foreign exchange reserves and maintained the currency’s stability against the dollar. But the loss of nearly US$1 trillion in foreign exchange reserves has tightened domestic liquidity and domestic interest rates have edged upwards.

This is expected, as outflows cause loss of renminbi deposits in exchange for foreign currency. So the central bank needs to provide continuous funding to ensure the domestic liquidity situation does not create a credit crunch. It needs to maintain a tight monetary stance, because excess liquidity flows out and hurts foreign exchange reserves; too little liquidity risks credit defaults. Getting the balance right is more an art than a science.

We currently have financial markets at record peaks in almost all the major markets, even though growth has not fully recovered to pre-crisis levels, while global debt levels are at record highs.

Meanwhile, geopolitical tensions are the gravest of concerns. A Bloomberg survey found half of more than 400 investment professionals rated geopolitics as the greatest uncertainty, with 47 per cent worried about Trump’s policies and 38 per cent concerned about Brexit. Only 3 per cent were worried about China’ growth outlook and policy landscape.

Despite record prices in US equities, 40 per cent of fund managers want to invest in the US, 28 per cent in Southeast Asia and only 10 per cent in Europe. Thus, the medium-term upside for the US dollar is intact, provided the Trump administration is able to demonstrate it can steer the economy to higher ground without political gridlock.

Betting on a stronger US dollar is today a mix of classic greed and fear. The US still offers good upside potential, despite record equity peaks and low interest rates, but there is always the fear that Trump will change the game with the next tweet.

Andrew Sheng is a distinguished fellow at the Asia Global Institute, University of Hong Kong