The U.S. dollar has surged since the unexpected victory of Donald Trump in November’s U.S. presidential elections. If the greenback’s ascent continues apace, it could rival the overshoot of the dollar during Ronald Reagan’s first term as president in the 1980s. However, we don’t think such an overshoot is a likely scenario.
Contrary to the expectations of most pollsters, Donald Trump won the race for the White House. Currency markets reacted fiercely, with the U.S. dollar surging against most other currencies. As measured by the Bloomberg Dollar Spot Index, the trade-weighted U.S. dollar jumped by 4.1% in the immediate aftermath of the election through November 21, 2016. The president-elect’s fiscal plans for the U.S. economy are more expansionary than Hillary Clinton’s. According to non-partisan projections, Mr. Trump’s fiscal plans would imply a much steeper rise in the budget deficit. If the U.S. economy operates close to full capacity, as it arguably does, economic theory tells us that a higher deficit leads to an appreciation of the currency via higher interest rates. Indeed, long-term U.S. bond yields have started rising sharply11. Some commentators contend that currency markets could see a repeat of the early 1980s when the real trade-weighted dollar surged into highly overvalued territory, as shown in the chart below. U.S. President Ronald Reagan at the time had implemented substantial tax cuts while the Fed under then-chair Paul Volcker kept interest rates high to extinguish the ghosts of inflation.
Repeating Reaganomics overshoot?
*The real effective exchange rate is the weighted average of a country’s currency relative to an index or basket of other major currencies, adjusted for the effects of inflation. The weights are determined by comparing the relative trade balance of a country’s currency against each country within the index. This exchange rate is used to determine an individual country’s currency value relative to the other major currencies in the index, such as the U.S. dollar, Japanese yen and the euro.
We think a repeat of the 1980s overshoot of the U.S. dollar is unlikely, although the greenback could strengthen a little further from current levels. The situation today is different from the 1980s insofar as the Fed under Janet Yellen is not fighting high inflation and is unlikely to be as hawkish as the Fed was in Volcker’s era. In addition, Mr. Trump’s protectionist and isolationist stance may weaken the dollar’s appeal as a reserve and safehaven currency. Weighing up these countervailing forces, we think a Trump presidency is indeed a net positive for the U.S. dollar due to the new president-elect’s fiscal plans. However, already rich valuations and limited scope for policy divergence will likely restrain the dollar’s upside potential against other developed market currencies to 5% to 10%.
Other major currencies
Euro (EUR) Political risks aplenty — such as upcoming elections in France and Germany — as well as loose monetary policy could keep the euro under pressure in 2017. However, the single European currency is supported by an attractive valuation, which limits how much further it could fall. We think 0.95 to 1.00 on the EUR/USD exchange rate is a constructive support zone.
Japanese Yen (JPY) The yen is in a similar situation to the EUR in terms of monetary policy because the Bank of Japan’s mix of bond purchases and negative interest rates exert a gravitational pull on the Japanese currency. While the yen may weaken further, it would become attractive at an exchange rate of 120 USD/JPY.
UK Pound Sterling (GBP) Although 2016 has been a horrendous year for the British pound, we believe it is now sufficiently cheap, rendering a fairly balanced ratio of reward-to-risk. We also think that there may be some softening of the UK government’s stance towards a “hard Brexit,” which should also be supportive of GBP.
Emerging market currencies
On the surface, the outcome of the U.S. presidential election is also bad news for EM currencies. President-elect Trump has supported greater restrictions on international trade, which, if implemented, are likely to hurt EM economies and could weigh on EM currencies. The Mexican peso fell sharply immediately following the election, for example, because Mexico is seen as particularly vulnerable to a possible repeal of the North American Free Trade Agreement (NAFTA).
While the threat of protectionism is a near-term headwind, the economic fundamentals of EM economies are improving and we think that many EM currencies are attractively valued. The U.S. president-elect’s economic policies are not universally detrimental to the economic prospects of EM countries. His plans for increased infrastructure spending may even benefit economies that mainly export raw materials, such as Brazil or Russia.
All in all, we think that the return potential for EM currencies, which has to take into account their high interest rates relative to developed-market currencies, is still good in a world where there are very few financial assets that are outright cheap.