A Cup Half-Empty View of the Dollar’s Outlook
December 4, 2018
My blog entry three weeks ago presented a mostly upbeat short- to medium-term view of the dollar’s outlook, although downside risks especially further out in time were cited, too. In the role of Devil’s Advocate, this follow-up piece has a more bearish hue, taking into account some shifting developments. U.S. President Trump’s bobbing and weaving communication skills have played an important role in stirring the countervailing forces and immediacy of factors lifting and depressing the dollar. But other forces may also be at play.
U.S. monetary policy seemed set three weeks ago, pointing to a likely fourth 2018 rate hike this month and three more in 2019. But in the wake of the midterm election, Trump went on the offensive regarding several issues, one of which was to cite Federal Reserve tightening under Jay Powell’s leadership as a bigger threat to future U.S. growth than even China’s predatory trade and industrial policies. Currency markets generally react adversely whenever political leaders seem to be interfering with the independence of monetary policy.
Turkey and Hungary provide two recent examples of this typical response, and Trump’s public griping was more blatant than criticisms made by previous U.S. presidents. Investor uneasiness in the latest instance may have been accentuated further because, coincidentally or not, Fed officials simultaneously appeared to have stepped back from the likely policy course presented until just recently. Some including Powell have suggested a need for caution, stressing that any tightening will be done with due prior deliberation and only to the extent that action is fully justified by unfolding economic and financial market data. Could Fed officials perhaps be caving in to White House pressure? Here image is as important as underlying fact.
Inflation trends in the U.S. and around the world have seen a retreat lately. The price of oil fell abruptly. Core inflation has also receded in places. Expected inflation in the market has slowed, too. The 30-year Treasury yield recorded its biggest daily decline in a half year today and is 30 basis points has narrowed to a mere 11 basis points, and the two-year Treasury yield is a basis point above its five-year counterpart. For some time, academics had debated whether an inversion of the U.S. yield curve during the coming year would or even should be taken as a harbinger of the next recession’s onset. That flashpoint is now at hand and if actually prophetic suggests a recession beginning perhaps as soon as late 2019 and, more assuredly, by mid-2020. That possible scenario presents a stark contrast to the robust U.S. growth actually achieved in this year’s middle two quarters.
How can the healthy recent economic experience by reconciled with such a quick turnaround, especially since U.S. interest rates remain historically low and given the huge fiscal stimulus this year? The chief suspect is President Trump’s aggressively provocative trade policy. Until recently, such was viewed mainly as a negotiating strategy, and parallels to the standoff with North Korea over missiles gave comfort. Trump creates a lot of drama with extreme rhetoric, suddenly agrees to meet face to face with his adversary, and proclaims huge success in such talks and an historic deal that will be great for America and the world. Even if the boast is untrue, the danger is defused, and markets and businesses can go forward happy in the knowledge that a big scare has been removed.
Except that China isn’t North Korea, and the U.S. has less clout on a purely economic issue than a military one. The U.S. contributes about 24% of world GDP, only 2.5 percentage points more than the EU’s share. China and Japan together have a share equal to the EU’s, and of all these regions, it is the United States that is now geo-politically most isolated. Like Germany in the 1940s, it would be hard for the United States to wage a two-front conflict.
The political crisis that has enveloped British Prime Minister May’s government is also a worrisome omen for the dollar. Britain has played the role of the canary in the mine to the United States. The unexpected voter approval of leaving the EU in the U.K. referendum of June 2016 foretold the equally surprising election of Donald Trump as U.S. president just four and a half months later. And so the government’s collapsing hold on power may also presage a coming constitutional crisis in America. Far greater than any threat of impeachment, the really big danger in the United States is that a constitutional republic designed nearly 250 years ago for conditions then existing no longer resembles a democracy, and no legal and politically plausible means exists for reestablishing a system that vests public-sector decision making back with a majority of the people.
The focus on an insular immigration policy and policies that promote 20th century industries to the exclusion of 21st century survival needs constitutes a huge obstacle to future investor confidence in the reliability of the dollar as the preeminent reserve currency around which hinges the international monetary system. Because of a lack of appealing alternatives, it’s been thought that this system, despite more noticeable blemishes, will not evolve into something quite different for many more decades. But consider this: the last recession was so transformative that it led to the rise of political nationalism just 10 years later, and the next recession could also be a whopper because historically low central bank interest rates and a colossal budget deficit will preclude use of the usual counter-cyclical macroeconomic tools to expedite a reasonably quick escape from the downswing. A vicious cycle of political and economic unraveling might ensue.
Finally, an historic tendency for the dollar to decline during the final two weeks of the calendar year against its main rival also offers up reason to be cautious about the period just ahead. In the early years of flexible dollar exchange rates, the U.S. currency fell between mid-December and end-December against the German mark 13 of 14 times from 1974 through 1987, and the average size of the dollar drop over that time period was 1.7% a year against the mark. The dollar’s main rival now is the euro, and it fell 1.1% and 2.1% against the euro in the second halves of December 2016 and 2017, respectively.
Copyright 2018, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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