Trump's Jawboning Alone Isn't Driving the Dollar
The dollar has been volatile since Donald Trump was elected president in November 2016. Measured by the U.S. Dollar Index, a gauge of the currency’s value relative to a basket of currencies, the greenback rose by 4.4 percent by the end of that year. Since the beginning of 2017, it has depreciated 3 percent, wiping out most of the gains. The decline coincided with Trump’s repeated statements that he wants the dollar to weaken to enhance U.S. competitiveness in global trade.
Can such presidential jawboning result in a prolonged depreciation of the currency? This is an important question for global players, including international investors and multinational corporations. Investors in foreign markets and companies with foreign sales want to know the major factors determining the dollar’s valuation.
In addition to their evaluation of prospects for U.S. equities, German investors are likely to weigh the change in the dollar’s value against the euro during their investment horizon. Similarly, U.S. investors make assessments of future exchange rates in deciding whether, and how much, to invest abroad. And U.S. corporations’ optimism about surging foreign sales may be tempered by a significant appreciation of the dollar over the same time period, reducing the dollar value of foreign sales.
Investors’ expectations over the short-term can be unduly influenced by Trump’s statements. After all, why would you want to fight the president if he wants the currency to be weaker? His words can have the opposite effect, too: As he explained last week that he would like to renegotiate the North American Free Trade Agreement, the dollar appreciated against both the Canadian dollar and the Mexican peso because investors saw the move as potentially shrinking the U.S. trade deficit. Still, investors need to look beyond to other, more fundamental, factors to decide where the dollar may go over the longer term.
The first thing to remember is that an exchange rate is a price determined by supply and demand. Just as the price of orange juice surges after a severe frost in Florida, there would be a relative scarcity of dollars if the Federal Reserve decided to print less. We would arrive at the same result if the European Central Bank increased the supply of euros, or if the Bank of Japan flooded the market with newly printed yen. And while the Fed has raised rates three times since the 2008 financial crisis, the ECB and Bank of Japan are still purchasing bonds from the open market, injecting cash into the markets.
On the demand side, investors want to hold currencies of countries growing faster, or whose equity markets are expected to perform better, than their own nations’. By these criteria, the U.S. has generally been a better performer than many of its major trading partners since the financial crisis. Yet underlying euro strength in recent months, economic growth numbers improved in several euro zone countries in the latest quarter while U.S. growth dropped to 0.7 percent, the slowest pace since 2014.
What seems common sense has a basis in economic theory. The Columbia University economist Robert Mundell explains that faster-growing countries have appreciating currencies because residents want to hold more money for the increased volume of anticipated transactions. Even if that country were to run a trade deficit -- as the U.S. does with several nations -- residents try to “import” cash from abroad through capital inflows. In turn, this causes the currency to appreciate.
This is what happened last year. This chart shows the U.S. balance of payments calculated by the International Monetary Fund as the sum of the trade balance, net interest and dividend payments, and net capital inflows. As growth lagged in the rest of the developed world, capital inflows to the U.S. largely explain the dollar strength.
What are some of the takeaways for investors?
First, rather than make decisions based on developments such as the Trump administration’s proposed 20 percent import tariff on Canadian lumber that has strengthened the U.S. dollar in the short-term, look for concrete measures to cut taxes or increase infrastructure spending that would boost growth and the currency.
Second, Trump’s measures to shrink the trade deficit may be counterproductive if they lead to trade wars, slowing the U.S. economy and weakening the dollar.
Third, lower oil prices would be positive for the U.S. economy because non-energy sectors form the bulk of the economy, lifting the dollar.
Fourth, actual Fed moves to hike rates or shrink its balance sheet would be dollar-positive since they would reduce the supply of dollars available.
With the U.S. economy likely to perform better than its developed-country counterparts, and the Fed’s monetary policy tighter than in Europe or Japan, investors should expect renewed strength of the dollar over the medium-term.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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