Foreign Exchange Heading into the Home Stretch Leg of 2018 Trading

November 13, 2018

The day after tomorrow will complete the 7th eighth of this calendar year. Unlike 2017, the dollar has performed well in 2018 and figures to retail resilience in the home stretch, notwithstanding an historical tendency to fade more often than not in late December.

Factors that have buoyed the dollar remain in place. Three increases already this year in the federal funds rate target will almost certainly be topped off be a fourth tightening at next month’s FOMC review of U.S. monetary policy, and released forecasts then will suggest several more moves in 2019. By contrast, the European Central Bank is only poised to stop bond purchases soon and has no plans to raise interest rates for a few more quarters. The Bank of Japan still has no set date for ending quantitative stimulus. Both banks have negative benchmark interest rates. Currencies tend to be more keenly influenced by short-term interest rates than longer maturities, and the short end continues to favor the dollar.

Economy-specific issues plague the yen, yuan and currencies of Europe. Some twenty years after deflation struck Japan, that economy still can’t seem to escape once and for all from that danger. The government in response has relied mostly in recent years upon monetary stimulus in the hope that its strategy given enough time will succeed and do so before the adverse side effects to Japan’s banking system do not overwhelm the intended benefits before 2% stable inflation can be secured. Like many other Asian economies, Japanese growth also faces the risk related to the U.S.-Sino trade dispute.

The imposition of tariffs on a massive amount of U.S. imports of Chinese goods has introduced a new headwind to an economy that already has slowed significantly. China experienced its first current account deficit in two decades during the first half of 2018, and October saw the country’s foreign exchange holdings drop by almost $34 billion, the most in 22 months and to its smallest level since April 2017. U.S. officials complain that Chinese officials keep the yuan cheap to promote trade, but the decline of reserves in fact indicates that intervention support has been needed to prevent the yuan from depreciating even more sharply.

Fewer than 20 weeks remain an original 104-week timetable for Britain to negotiate post-Brexit arrangements with the rest of Europe. Either no accord will be worked out, or it appears that a rushed and bad deal will result. Brexit has driven a wedge between Britain and its former European allies, but it has also damaged the U.K.’s internal politics. Neither development is good for sterling. Since bottoming at 1.4378 per pound seven months ago, the dollar has climbed about 11% against the British currency.

Brexit also hurts the euro and other currencies. At $1.1212, the euro touched a new 2018 low today, which represents the same percentage loss vis-a-vis its 2018 peak against the dollar as seen in sterling. Confidence in the euro has also been shaken by the recently elected Italian government, which has adopted a maverick fiscal stance that defies Euroland rules. A few years back, Greek fiscal excess posed an existential threat to the common currency area until ECB President Draghi promised that the bank would do whatever it takes to preserve the euro. Greece was neither too big to fail nor too big to be rescued, but the same cannot be said about Italy.

U.S. President Trump has turned domestic and foreign policy precedents on their head, alienating an awful lot of Americans but even more people in other countries. The optics of the centennial observances of the WWI armistice cast America’s isolation from the rest of the world in a stark light, and some 57% of votes cast for the U.S. congress earlier this month were directed against Republican candidates but in fact a vote of no confidence in the Trumpian way of making the country great again. That being said, America’s unique architecture of government is likely to keep the president largely free of political restraint from staying and extending the course that he has charted. Accordingly, U.S. political uncertainty isn’t a clear and present danger to be considered by holders of dollar-denominated assets.

Trump’s foreign policy exports uncertainty to other countries, however, and their currencies could be adversely affected by the consequences. The pendulum around the world is still swinging from globalism toward nationalism, and this could hurt confidence in non-dollar paper currencies.

A big mystery is when does the short run give way to the long run, and what sorts of developments might throw that switch. I remain bearish long term on the dollar, but this is not the time to act on that concern. Nobody expected the Spanish Inquisition, and just about nobody expects dollar hegemony among reserve currencies to end, or even get shared, anytime soon. Many assume the dollar will be a hegemon for decades to come. However, if Trumpism outlasts the movement’s leader, a time is bound to come when the international monetary system will be susceptible to transformation as sweeping as that which was experienced in the first half of the 20th century. In light of massive outstanding offshore holdings of U.S. currency, a big slide of the dollar could then ensue.

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



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