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The outlook for the US dollar – A Self Fulfilling Prophecy?
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The outlook for the US dollar – A Self Fulfilling Prophecy?

Chris Towner Weekly bulletin August 2018

Prophecies in the FX markets can end up being self-fulfilling. We are witnessing one at the moment with the US dollar. It starts with an improving economy and this leads to expectations and realities of higher interest rates, which strengthen the currency.

So how has the US economy improved? Back in January 2017, when Trump was inaugurated, the Dow Jones was trading sub 20k (now above 25k and supported last week by the unveiling of Apple as the first company to reach a trillion dollar valuation); the unemployment rate was 4.8% (last week’s release of July’s employment report unveiled a further dip in the unemployment rate to 3.9%); and annualised GDP was 1.2%, compared to last quarter’s spectacular reading of 4.1%. However, you cannot digest all this good news on the economy without a couple of tweaks to the Fed’s target range for its interest rate, which to Trump’s annoyance has gone up by 1% to 1.75%-2.00% since he has been in office.

So what has been going on with the US dollar? As the US economy has gathered momentum, so too has the value of its currency. It was only in April of this year that GBP/USD was trading at levels above 1.4300, whereas it is now almost 10% lower. Meanwhile, EUR/USD has dropped from levels above 1.2400 to trade in the 1.15’s – a 7% increase in the value of the dollar. (Incidentally, this bulletin argued back in January that these movements were likely to take place).

However, this particular self-fulfilling prophecy does not end with the greenback strengthening into the sunset. A combination of higher interest rates and a stronger currency tends to act as a brake on economic activity. We know that higher rates in the US will start to attract savers more than borrowers. Savers save for the future to spend later, borrowers borrow now to buy now, which stimulates the economy. So higher rates will deter borrowers and this slows investment.

In addition, a stronger currency makes exports more expensive and encourages imports. Donald Trump knows this. In his determination to negotiate on trade, especially with China, the pressure he is putting on the Chinese economy by threatening to raise the rates of proposed tariffs on 200bn USD of Chinese exports to 25% is resulting in a weaker CNY and therefore by default a stronger US dollar. Since the second week of June we have seen the Chinese renmimbi weaken against the US dollar by almost 7%. Trump thinks he is negotiating from a position of strength whereas in reality the more pressure he places on China, the weaker the Chinese currency becomes. With regards to the trade balance, a devalued currency plays into the hands of the Chinese, who can therefore afford to sit this one out for the long term.

And we have seen clear signs that the strengthening of the US dollar is having a negative impact on trade. Last week’s release of trade data showed the US to have the largest deficit in 18 months with the trade gap surging by 7.3% to 46.3bn USD in June. This is what happens when the products you sell overseas become more expensive. They buy less, and when foreign products become cheaper in the US, domestic consumers buy more.

Hence the self-fulfilling prophecy continues, but with the USD ultimately reaching a level where it begins to have a negative impact on the economy and slow it down.The next presidential election is due to take place in 2020. As Trump enters his second half, you can see why he doesn’t want higher rates and a stronger dollar impacting growth. The market is also keeping a very close eye on any signs of slowing economic activity and you can be sure that at the first sign of this, there will be a rush for the exit by those holding dollars.

Trump’s risk is too much to hedge, but please get in touch if you would like to discuss your US dollar exposure or indeed any other currency.

Upcoming economic releases

This week the focus remains on trade disputes and Brexit as well as the heatwave!

Monday

  • Eurozone 7am German Factory orders (previous 2.6%, actual -4%)

Tuesday

  • Eurozone 7am German Industrial production (previous 2.6%, expected -0.5%)
  • Eurozone 7am German Trade balance (previous 20.3bn Euros, expected 20.1bn Euros)

Thursday

  • UK 12.01am RICS Housing Market Survey (previous +2; expected +4)
  • US 1.30pm PPI ex Food and Energy (previous +0.3%, expected +0.3%)

Friday

  • UK 9.30am Q2 GDP preliminary 0.4% (previous +0.2%; expected +0.4%)
  • UK 9.30am Manufacturing Production (previous 0.4%; expected +0.3%)
  • UK 9.30am Goods Trade balance previous (previous -£12.4bn, expected -£12bn)
  • US 1.30pm Core CPI m/m (previous 0.2%, expected +0.2%)
 

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Contact us

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