Three ways to make sense of the dollar in uncertain times

Posted on November 15, 2016

The only reliable guide to the dollar’s value in the wake of Donald Trump’s electoral victory is the wisdom of legendary investor Bernard Baruch about the stock market: it will fluctuate. If the prospects for the US economy have never been so uncertain, then the prospects for the dollar similarly have never been so uncertain.

Still, we can attempt to make sense of this scenario from three angles. A first is from the vantage point of US fiscal and monetary policies. One thing we know is that a more expansionary fiscal policy is coming. It may take the form of tax cuts for the wealthy and tax credits for investors; or it may be a more balanced programme, including a significant rise in infrastructure spending.

Either way, growth and inflation are likely to accelerate, and the US Federal Reserve will respond by raising interest rates sooner and faster. We know from the Reagan era that a mix of loose fiscal and tight monetary policies makes for a strong dollar. No surprise, then, that investors are bidding up the greenback.

But we also know that doubts about debt sustainability can lead those investors to think twice. Large, unfunded tax cuts will heighten their doubts. Questions about fiscal sustainability will be particularly troubling to investors in US Treasury bonds, given Mr Trump’s offhand comments about renegotiating the debt.

Thus the macroeconomic policy mix should be dollar supportive in the short run but dollar subversive in the longer term. If markets are myopic, then the dollar will continue to strengthen for the moment. But if investors look forward, that moment will be relatively brief. Anyone care to bet on its duration?

A second perspective flows from the likelihood that the new administration will adopt protectionist policies. Taxing and otherwise discouraging imports will strengthen the US trade accounts, and a smaller trade deficit will be dollar positive. The increased price of imports will translate into modestly higher inflation, again encouraging the Fed to raise interest rates sooner and enhancing the appeal of dollar-denominated assets.

But those same trade policies run the risk of provoking foreign retaliation, with precisely the opposite effect. New tariffs will also reduce the efficiency of US production by disrupting global supply chains. If the result is slower growth, investing in the US and the dollar will be less attractive. Hence the new administration’s trade policies are likely to be dollar positive in the short run and dollar negative in the longer term.

A third perspective is the dollar’s haven status. The greenback benefits from uncertainty. Even when the US is the source of the problem, its currency benefits. The US Treasury market is the most liquid financial market in the world, and there is nothing investors value more in a crisis than liquidity. Thus some will argue that heightened uncertainty from Mr Trump’s accession to power will benefit the dollar.

This view fails to appreciate the deeper roots of haven status. These go beyond deep and liquid markets. The policies of the central bank issuing the currency and the government standing behind it must also be sound and stable.

A currency is regarded as a haven only if the country issuing it is geopolitically secure. It must have a strong military but it also must have strong alliances. The pound was the haven currency before the dollar because Britannia ruled the waves and because Britain successfully constructed a web of geopolitical alliances.

So whether Mr Trump adopts policies that heighten trade tension with China, scales back US foreign commitments and turns his back on Nato will tell the tale. The fate of the dollar, and potentially much more, will turn on the answer.

The writer is professor at the University of California, Berkeley, and the author of ‘Exorbitant Privilege’

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