The Dollar conundrum

When it comes to financial market sell-offs, the US dollar can usually be counted on to act as a safe haven and gain in strength. And this is true even when the catalyst resides within the US borders. As global equity markets suffered one of their worst days in over half a decade on Monday 5 February, the US dollar gained 0.5% against other major currencies, as measured on the US Dollar Index (DXY).

Michala Marcussen, Societe Generale’s Group Chief Economist

Michala Marcussen, Societe Generale’s Group Chief Economist

Although this move is far from spectacular, the fact that the US dollar is finally behaving in line with what most market participants would expect in such a situation offers some small comfort in what are otherwise challenging markets. Moreover, it makes a welcome change from the puzzling behaviour of the dollar in recent months. Turning the clocks back to early 2017, the consensus was looking for euro/US dollar exchange rates to average around 1.06 in early 2018. This compares to 1.20 at the close of 2017 and 1.22 on average so far this year.

Both the US Federal Reserve and the European Central Bank have delivered monetary policy broadly in line with consensus opinion over the same period. Looking at the 2-year bond yield spread between the US and Germany, this has in fact widened by around 70 base points since early 2017. All else being equal, the interest rate parity theory suggests that this should have triggered dollar appreciation, but instead quite the opposite has happened. In such a situation, it is quite logical to look to inflation expectations. However, across that Atlantic, the relative inflation shift is not of a sufficient magnitude to suggest that purchasing power parity has been the dominant effect. To our minds, rather, the explanation is to be found in the realms of growth and fiscal policies.

Looking first at growth expectations, both the euro area and the United States have seen upward revisions of the 2018 growth outlook. But while consensus opinion has added around 0.3 percentage points to the US outlook over the past year, increasing it to 2.6%, the gains for the euro area outlook have been just over double that, rising growth outlook to 2.2%. This move offers a first case for euro appreciation.

Further justification for the dollar depreciation against the euro (and for that matter other major currencies) is found in public finances. Over the past year, the consensus view on the US budget deficit has deteriorated significantly in tandem with the growing likelihood that the Trump administration would succeed in passing tax reform through Congress. A tax cut plan worth an estimated $1.5tn over the next decade was finally adopted just before Christmas. Consensus opinion now looks for the US budget deficit to come in at 3.7% of GDP in 2018 and 4.3% in 2019. This compares to 3.3% and 3.4%, respectively, in early 2017. Meanwhile back in the euro area, the consensus estimate for the budget deficit has improved with a deficit of 1.1% forecast for 2018 and 1.0% for 2019. This offers an additional factor supporting a stronger euro. The euro area, moreover, boasts a current account surplus that stands in contrast to the US deficit. While this is an argument in favour of euro strength, there has not been much change on the consensus outlook for this variable over the past year.

With so many forces weighing in on currency markets, judging where markets go next is no easy feat. In the first instance, the dollar seems likely to enjoy some further support from its safe-haven status as markets look for firmer footing. Assuming that the recent risky asset price declines prove to be a correction rather than a profound and long-lasting slump, then the answer to the future path of the dollar is set to be determined by the success or failure of the Trump administration’s demand-side economics.

In the first instance, the US tax cuts are set to give a boost to the demand side of the economy. At a time when the US economy is already close to operating at full capacity, this seems likely to add to inflationary pressures. Indeed, it is this prospect that placed markets on edge, raising concerns of a more aggressive response from the Federal Reserve in terms of tightening monetary policy. As highlighted by Fed Chair Janet Yellen in a speech back in October 2016, there is a case to be made that a prolonged period of weak demand will destroy supply. The question is whether a period of stronger demand conversely can break the hysteresis phenomena (where changes in one part of the economy take time to have an effect on other parts), lift the supply side and thus ease inflationary pressure. This is certainly what the Trump administration is hoping for.

The key variable to watch in this context is business investment. So far, the anecdotal evidence is encouraging with several flagship US companies promising to raise investment spending. Stronger investment would not only lift productivity, but also alleviate capacity constraints and offer much more life to the US cycle. This in turn would plead in favour of a stronger dollar, all else being equal. Should the Trump administration’s policies fail and tax cuts merely add to inflation and weigh further on the budget deficit, then further dollar depreciation seems likely. This debate is unlikely to be resolved anytime soon, and the debate is likely to drive markets throughout much of 2018, switching at times between inflation fears and confidence that productivity gains will materialise. In a nutshell, solving the dollar conundrum is likely to prove to be a choppy process.

Article published on 15 February 2018 in L’AGEFI