Just buy the Dollar and shut your eyes? If only it was that simple .....

Tuesday 15th November 2016

  

Just buy the Dollar and shut your eyes? If only it was that simple .....

ref:- "Dollar emerges as a compelling Trump trade", The Financial Times, Markets and Investing

As we know, it didn't take long for investors to abandon their preconceived notions of what a Trump win would mean for markets ..... effectively, it was a few hours. Bond markets for example were expected to be the beneficiaries of a short-term flight-to-quality but almost immediately focused on Mr Trump's extensive plans for increased fiscal stimulus. The kind of infrastructure spending and tax cuts that he's got in mind do not come cheap and will have to be financed through bond issuance. Even if you accept a swelling of an already large budget deficit, the measures are of course inflationary and in that light expectations of a faster pace of rate hikes and a bond market sell-off (with yields soaring) seem eminently logical.

And what about the Dollar? Accepted wisdom had it that Trump's protectionist trade policies would hurt the greenback, at least in the short-term. Think again ..... again! The focus of attention in FX markets has been squarely on rising rates and bond yields in the States whilst Europe and Japan still contemplate further monetary easing. In other words, the divergence trade that sees investors buying and selling currencies on the back of interest rate differentials (in this case buying USD and selling just about anything else) is back in vogue. We've seen the trade-weighted Dollar Index above 100 for the first time in almost a year, a level that represents a near 8% rise from its lows set in May. So is this a new longer-term trend, and just the first leg of a journey towards a much stronger Dollar? Some analysts think so .....

As it happens, for the first time in almost a week the Dollar is on the defensive this morning, just as bond yields have pulled back a little. That's not very significant ...... nothing moves in entirely straight lines and the markets were due a breather, but it does give us a moment to have a quick look at competing points of view. The FT quotes Marc Chandler of Brown Brothers Harriman, who likens Mr Trump's plans to those of the Reagan administration of the 1980s  --  albeit with some provisos. In an eerily familiar scenario, Mr Reagan and his Fed Chairman  Paul Volcker introduced tax cuts and heavy government infrastructure spending at the same time as rate hikes to control inflation (see, told you it was familiar). The result? A rise of 45% (yes, that's 45%) in the value of the dollar from Reagan taking office to the high of February 1985.

Now, the incoming President's measures will not be as dramatic in scale as those implemented under the banner of Reaganomics. But the Dollar should get a further boost if promises to reform the tax on the repatriation of corporate holdings held overseas are carried through. All in all, Mr Chandler sees a 20% rise in the Dollar. To put that into context, that would equate to the Dollar matching its all-time high against the Euro of 0.8270 set in October 2000.

There's no shortage of Dollar bulls, though not too many are on record as being as bullish as that. Luca Paolini of Pictet is not one of them however, and he highlights three main reasons to be wary about the Dollar's prospects:

The inclusive tone of Mr Trump's acceptance speech may have turned markets around, but the initial, albeit very brief, move lower for the Dollar betrayed real concern about policies. The issues of protectionism, tighter immigration and isolationism may not be the ones most discussed at the moment, but they have not gone away and could prove damaging to the US unit in the future.

There may be similarities between the Trump plans and Reaganomics but the Great Communicator did surround himself with some pretty smart people. The jury is still out on whether Mr Trump will do the same, although early signs are not altogether comforting. That's a shame, as he's going to need some help in dealing with a Congress that may have Republican majorities in both the Senate and the House of Representatives but is not necessarily stuffed with Donald Trump fans.

And what about his relationship with Fed Chair Janet Yellen, who may not forgive and forget his campaign trail accusations as easily as some others seem to have done. Conflict between the administration and the Fed would spell trouble for the currency.

Perhaps most fundamentally, Mr Paolini points out that the "then and now" comparisons are flawed : in the 1980s the dollar was hugely cheap, so a huge rally was not a surprise. US assets were cheap too ..... and nobody could argue that's the case now.

The truth of the matter is that we are just one week on from the election. We know that Mr Trump is making conciliatory noises, but we don't know what his administration will actually look like or whether they will abandon some of their more controversial pre-election manifesto. We can see why the Dollar is strong right now, but to conclude that it has embarked on a long-term bull run is something of a leap. The President- elect and his acolytes seem a very unpredictable bunch to start basing assumptions on.