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The bull case for the US dollar

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Almost exactly one year ago, the audience at a conference for corporate treasurers was asked to vote on whether it thought the US dollar would strengthen or weaken over the subsequent 12 months. The verdict – that 2017 was set to be a good year for the greenback – was close to unanimous, and came with an explanation over which there was broad agreement. While opinion remained divided over the freshly inaugurated President Trump’s suitability for office, the consensus view held that his administration was likely to be a favourable one for US business. Cuts to the corporate tax rate, an amnesty over the repatriation of overseas profits, and a rolling back of the administrative state were all going to stimulate the country’s economy. Continued reduction in unemployment, combined with sustained wage growth, would at last allow inflation to take hold, creating an environment in which the Federal Reserve could happily continue to raise interest rates. And all of this would lend support to the country’s currency.
 
As we now know, however, those bets on dollar strength were misplaced: it finished the year down 7% on a trade-weighted basis against a broad basket of currencies, 10% against sterling, and nearly 15% against the euro. Yet the expectations of one year ago, though on the optimistic side, were not entirely wrong-headed. The White House may have had few legislative successes, but a significant cut to corporate tax – from 35% to 21% – was one of them. The ‘one time only’ offer for companies to repatriate overseas profits at a reduced tax rate led Apple, for example, to make a record one-off payment of $38 billion to the US Treasury. The unemployment rate hit a 17-year low on the back of continued job growth, and annualised GDP growth, as at the third quarter of 2017, was a healthy 3.2%. So what happened to the dollar?
 
The obvious answer, that it weakened as a result of chaos and dysfunction within the president’s administration, is tempting. But it is not good enough. Commentators may like the idea that a currency’s exchange rate acts as a sort of international approval rating for the country by which it is issued, but the reality is more pedestrian: it responds to capital flows and to the actions of speculators who are trying to turn a profit. One consequence of this is that by the time there is a near-unanimous consensus that an exchange rate will move in a given direction, the likelihood is that it has already done so. The dollar did not fail to strengthen in 2017 because the US economy performed badly; it did so because expectations of good performance had already been baked into the price, so the fact that these were largely realised did not provide the greenback with any further support.
 
Looking ahead to where the dollar will go in 2018 then, we have to ask which factors have already been priced in to the current exchange rates, and to what extent they represent a consensus view. In doing so, what emerges looks curiously like a mirror image of the position we were in a year ago: there seems to be pretty broad agreement that further weakness is ahead.
 
As before, there is a plethora of arguments given for this position, many of which seem eminently reasonable. It is one thing to say that a chaotic White House alone does not inevitably lead to a weak currency. It is entirely another to excuse one that has brought about the first shutdown of the US government in history to take place while the presidency and both chambers of Congress are under the control of a single party. Moreover, the reasoning is not confined to the US side of the equation. As The Economist argues in this week’s edition, a broad-based upswing in global economic growth means that the US is looking less and less like the only game in town for investors, resulting in capital rushing into currencies other than the dollar.
 
Taking history as our guide, though, what matters is not the quality of these arguments but the degree to which they have already been accepted by market participants. If, as seems to be the case, we have reached a position where there is little to no debate over their validity, they have ceased to matter – the price movement has already happened.
 
There are plenty of reasons to believe that several major currencies will depreciate against the dollar over the course of 2018. For sterling, which recently crept up to within striking distance of its pre-referendum level against the dollar, there is the threat that the second phase of Brexit negotiations will reopen those issues that were supposedly resolved in the first, delaying any agreement and potentially even endangering a transition period. Nor is the euro unassailable, with the question over Germany’s next government still unresolved four months after a general election.
 
By far the most compelling argument, though, for a strengthening dollar is the depth of the consensus that it will move in the other direction. At the point where an internationally circulated newspaper is using one of its leaders to make a currency call, it seems a fair bet that the smart money has already moved. It is far too easy to make the case for dollar weakness – so easy, in fact, that it is probably wrong.
 
Upcoming Economic Releases
This week sees a number of key economic data releases, although none where significant changes are expected. Tomorrow (Tuesday), we will get the UK Public Sector Net Borrowing figure for December. Wednesday then sees the preliminary PMI figures for the eurozone in January: services expected at 56.4 (down from 56.6 last month) and manufacturing at 60.3 (down from 60.6 last month). Finally, the ECB announces its refinancing, marginal lending, and deposit facility rates on Thursday, where for each of these no change is expected from the current figures of 0%, 0.25%, and -0.4% respectively.

 

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