Dollar Reflections on a Snowy Day Early in January

January 4, 2018

Economic fundamentals improved last year in the United States and many other countries. Real activity grew faster. Inflation pivoted away from being troublesomely low to levels that still remained weaker than desired but ones that permitted monetary policy normalization to proceed gradually. Current account surpluses were experienced in the usual suspects such as Germany, Switzerland, Japan and China, and America’s deficit remained quite manageable. Ten-year sovereign debt yields ended 2017 within five basis points of their end-2016 levels in the United States, Japan, Switzerland and Great Britain. The German bund yield rose by a somewhat greater 22 basis points. Share prices experienced double-digit advances in the U.S., Japan, Germany and Switzerland.

The good economic fundamentals of 2017 stood in contrast to worrisome political developments. Confidence in and respect for democracy took a big hit, most notably but hardly exclusively in the United States. It’s not clear in the brave new world of social media that governance vested with freely elected representatives of the people can work effectively for the common good.

The partisan U.S. tax bill may goose economic growth this year, but it will also accelerate the inequality of the distribution of that incremental growth, and that will  challenge the nation’s social cohesion. The Soviet Union succumbed almost 30 years ago not at the hands of a foreign foe but internally from being unable to provide basic government services for its people. The vacuum left by America’s new path is being filled by an emboldened China, where consolidation of the power in the hands of President Xi and the Communist Party that he leads makes him that country’s strongest authority since Mao.

The dollar failed to capitalize  the favorable U.S. economy, falling over 7% in 2017 on a trade-weighted basis. The dollar declined in each quarter of the year against the euro, losing 12.3% in all. The greenback also lost 8.7% relative to sterling despite the significantly larger relative size of the U.K. current account deficit and uncertainties related to how Brexit will impact the London’s global leadership in foreign exchange and other financial services. The dollar lost 7.6% against the Australian dollar, 6.5% versus the Canadian dollar, 6.3% vis-a-vis the Chinese yuan but only 4.3% to the Swiss franc and 3.6% against the yen.

While the favorable economic fundamental trends in the U.S. and other major countries ended last year showing an acceleration of upward momentum, 2018 appears fraught with continuing great uncertainty on other criteria. Although a free-for-all trade war didn’t materialize last year, nothing has been done to defuse that threat. Geopolitical crises could erupt  in hot spots such as North Korea, Pakistan and Iran. Choosing South Korea to host the Olympics in February doesn’t look like a sound idea anymore. The European Union ended 2017 in stronger political shape than at the start. However, Germany still hasn’t formed a ruling coalition, and Italy’s scheduled election in March could produce another nationalistic threat to Europe’s economy. Another time bomb is posed by the Mueller investigation into Russian efforts to influence the U.S. election in 2016 and whether the Trump campaign helped that effort.

Economic factors most often dominate political distractions in the long run, but the current cross road feels different. America’s former place in the world is in upheaval, and until the new order becomes clear, nothing else may be as important in determining the external value of the dollar. From a growth rate of 3.0% in the second half of 2017, U.S. GDP might have to surpass 4.0% throughout 2018 to create sufficient pleasant surprise to reverse the dollar’s direction. The Fed raised rates three times in 2017. Four moves this year might be possible, but it could take five or six to make a strong impression on the market. The dollar’s drop in 2017 followed a lateral move in 2016 and rise in 2013. Historically, the dollar has tended not to change direction year by year. Without a clear triggering event to change medium term sentiment toward the currency, either a trendless year of some further depreciation seem more probable than significant cumulative appreciation.

Copyright 2017, Larry Greenberg. All rights reserved. No secondary distribution without express permission.




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