How Trump's Trade Agenda Will Affect the Dollar
Foreign-exchange markets are trying to determine what an era of tariffs and border taxes would mean for the value of the dollar.
In textbook models, a border-adjustment tax could trigger an increase in the value of the real effective exchange rate (a measure of a country’s competitiveness once the nominal exchange rate -- the currency traded on the spot markets -- is adjusted for inflation and trade balance). The textbooks also say that it could increase the cost of exports and reduce the cost of imports by an amount that would exactly offset its direct effects. That would then allow the real exchange rate to revert to its natural “equilibrium rate” through a nominal appreciation of the exchange rate because of domestic currency demand resulting from a boost in exports and reduction of imports.
This is not always the case in practice. The real effective domestic exchange rate can overshoot the nominal foreign-exchange rates for longer periods because tariffs and taxes cause trade imbalances. Figure 1 shows how the real effective dollar index has significantly diverged from the nominal emerging market and Asia dollar currency indexes since 2014. If a new era of trade policy has begun, could the real dollar index continue to overshoot?
There are several ways to explain why the real dollar could continue to appreciate. For one, inflation differentials between developed and emerging markets could be shifting. As commodity markets rebalance the supply glut and China continues to experience a rapid rise in its producer price index, higher energy prices have already caused headline consumer price index rates to rise faster in the U.S. compared with other emerging markets. Second, the Federal Reserve has more firmly endorsed the rate path implied by the dot plot. It also has more openly discussed how it could unwind its $4.5 trillion balance sheet. With U.S. nominal rates rising on pace with or potentially faster than inflation, U.S. real interest rates should normalize, which could, in turn, strengthen the dollar. Uncertainty stemming from political events such as the elections in Europe could also return flight-to-safety capital to the dollar.
Foreign-exchange markets, however, have so far been trading on the assumption that the Fed once again cannot deliver its intended rate hikes for 2017. Fears of trade protectionism hurting the U.S. economy have put pressure on the dollar, which, for the year to date, has lost about 2 to 4 percent in nominal terms and about 1 percent in real effective terms. For foreign-exchange investors, dollar depreciation has presented the opportunity to explore other currencies like those of emerging markets. A popular metric to value emerging-markets currencies is “risk-adjusted carry.” This is defined as the real interest rate differential adjusted for inflation. That differential is divided by foreign-exchange volatility to express it as a return or “carry” as foreign-exchange traders call it. When the return is highly positive, it says an investor earns a return from investing in currency for the lowest unit of volatility. Figure 2 shows the risk-adjusted measure compared to the “implied FX carry.” This is the nominal rate implied from FX forward rates. Based on these two metrics, emerging-markets currencies may attract capital because the real rate differential is more than sufficient to cushion rising inflation and potential trade protectionism emanating from a change in U.S. trade policy.
A second reason that FX markets have some doubts about the appreciation potential of the real dollar, is demonstrated by the inverted shape of “currency basis swap” curves for several emerging market currencies (Figure 3). A cross currency basis swap is one where one party borrows currency from another and simultaneously lends the same amount at current FX spot rates. The inverted shape of the basis swap curve suggests that borrowing short term in emerging currencies cost prohibitive compared with lending in dollars. Bond investors seeking to swap local short maturity bonds from emerging markets to U.S. dollars may encounter a significant negative interest rate differential. In other words, a local EM bond yielding 6 to 8 percent may imply a very low to negative yield if swapped swapped to dollars. Although demand for dollars in markets such as China, Turkey and Mexico can remain high, ongoing tightening by the central banks of these countries may eventually erode dollar demand, thereby limiting appreciation of the dollar to an extent.
Finally, forecasts by FX strategists of the dollar index value show they expect an appreciation of 3 to percent by the end of 2017. Based on this expectation, the positioning in FX futures market shows a record net long dollar position since the U.S presidential election. Such large positioning may turn into a negative technical factor when forecasts of the dollar are downgraded. And markets are showing doubts here too as the trend in the real effective dollar index shows in Figure 4. With waning demand for dollars globally for now, a correction in the real effective dollar may continue. Despite looming tariffs and taxes, the appreciation potential for the real dollar looks a bit shaky, at least in the eyes of foreign-exchange markets.
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