An Enigmatic Dollar

May 1, 2018

The book has now been written on the first third of 2018. The dollar had underperformed expectations in 2017, falling 12.3% against the euro, 8.7% versus sterling, 7.6% vis-a-vis the Australian dollar, 6.5% against the Canadian dollar, 6.3% versus the yuan, 4.3% against the Swiss franc, and 3.6% relative to the yen. Recent currency movement tends to influence expectations about the future, and market chit-chat entered 2018 in a cautious mood about the dollar.

Overall, the dollar has traded more firmly up to the May Day break, but its route has not been direct. Against the euro, the dollar see-sawed down 3.3% in January, up 1.7% in February, down 1.0% in March, up 2.0% in April and at this writing shows nil net change for the year. Sterling also switched direction in each month and currently has a fractional net advance. Whereas the dollar recorded a comparatively small 2017 decline against the yen, Japan’s currency this year has so far strengthened 2.6%, but the U.S. currency has climbed 4.2% and 2.6% against the Australian and Canadian dollars, as well as 2.1% relative to the Swiss franc.

The reasons for greater dollar buoyancy are not clear. The perceived likely number of federal funds rate hikes in 2018 hasn’t changed much. U.S. share prices have been volatile, with a skewed tendency to fall more than rise. President Trump’s voter support has drifted higher, which seemingly should be a negative from an international perspective because of the intrinsic inconsistency of U.S. foreign policy in matters of commercial trade and military alliance. In 2017, the Trump administration focused on domestic economic policy, reducing regulations and securing a tax cut that is expected to promote stronger growth this year. In 2018, the focus has turned to trade, but the threatened protectionist response is unlikely to reduce U.S. global deficits and will instead drive growth lower and inflation higher. There is also concern about an unhealthy and ill-timed rise in the U.S. fiscal deficit. Deficits with falling U.S. inflation and interest rates have at times in the past been a recipe for dollar appreciation, but deficits with rising inflation have not been supportive even at times of decent economic growth.

It is surprising, too, that the dollar should be buoyant in the face of an erosion of key factors underlying the dollar’s role as the world’s dominant reserve currency. The dollar earned that specially advantageous status not because America is the world’s biggest trader but rather because of several desirable properties associated with the United States: the primacy of rule by law, not of people; the best public education system with plentiful policy support; open immigration to attract top talent from around the world; confidence by other nations that America can be trusted to keep its word; and a free domestic press. It would never have made sense for the dollar to have acquired a central role in the post-WWII international monetary system if these intangibles had not been in place, and it’s unreasonable to expect the dollar’s hegemony to persist as strongly as now unless Trumpism proves to be a passing phase.

It’s become much harder to accept such an assumption in 2018. Trumpism pre-dated Trump and is bigger than he or any other single individual. What one sees now is what one can reasonably expect to continue in America, and it doesn’t seem compatible with the foundations of the international monetary system as presently configured. Barring mega-shocks like the two world wars or Great Depression, the transition from one financial system to another happens slowly, however — more as an evolution than a revolution.

A disconnection between dollar buoyancy in 2018 and grave concern around the world about developments in the United States is also promoted by the inherent prioritization of short-term considerations over longer term matters in day-to-day financial market dynamics. This process is reinforced by the widening importance of machine-driven trading.

While intuitive explanations of the dollar remain elusive, two other currency relationships bear mention this May Day. The first concerns the Swiss franc. Upward pressure on the franc against the euro had been fiercely countered by the Swiss National Bank via intervention sales until mid-January 2015. Quantitative stimulus by the European Central Bank to do “whatever it took to preserve the euro” during the debt crisis had subjected the franc to enormous upward pressure. Switzerland was importing deflation, and its monetary authorities drew a line in the sand at 1.2000 francs per euro. The automaticity of the intervention was ended in mid-January 2015, plunging the euro from CHF 1.2012 on January 14, 2015 all the way to CHF 0.8600 on the next day. It’s taken a long time to get back. The euro averaged CHF 1.0900 in 2016 and CHF 1.1117 in 2017 but touched CHF 1.2011 on April 20, 2018. This return has been possible because the ECB is now seemingly winding down quantitative stimulus.

The other circular currency journey involves sterling and is still incomplete. Brexit was not expected to be approved by British voters in the referendum of June 23, 2016. Sterling fell from $1.5006 in the wee hours of June 24 to $1.1988 by January 16, 2017 in response. Last month, sterling touched $1,4377 on the 17th of April, having reversed 79% of its post-Brexit loss. But the pound has fallen more recently amid a slew of weak British data including the softest economic growth in 21 quarters, which occurred in the first three months of this year. Before the dollar acquired hegemony in the international monetary system following the second world war, sterling held that position, and even as late as the start of November 1967 traded as strongly as $2.80 in the old fixed exchange rate era. At its softest floating rate valuation, sterling was only worth $1.0345 in late February 1985. Currencies like sterling with enormous offshore holdings built up over decades are especially vulnerable to selling pressure when their basis of support becomes unglued.

Copyright 2018, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

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