By Mike Dolan
LONDON (Reuters) – It could be the currency markets’ turn to play bad cop against the new U.S. administration’s proposed rate hikes, brushing aside trade threats by catapulting the dollar higher.
In recent decades, market protests have typically involved so-called bond vigilantes, with creditors demanding sky-high interest rates in response to ill-advised government budgets, making the plans unaffordable.
But with Donald Trump’s protectionist trade proposals – including a 10% universal import tariff and a 60% levy on goods from China – now looking big, it is the currency markets that appear to be picking up the bat.
Much to the chagrin of the president-elect and his advisers, the dollar is already rising to a two-year high against the currencies of America’s main trading rivals, negating the competitive position Trump wants to protect with his tariff plans.
A rising dollar helps restore the pricing power of overseas exporters selling to the United States by flattering sales in their home currencies, allowing them to keep dollar prices low and maintain market share despite the surcharges.
The euro’s decline of almost 7% in less than two months has partially offset the pain of a 10% tariff that hasn’t even been implemented yet. The weakening from 4% over the same period is more modest given the draconian tariffs proposed against Beijing – but the direction in which it is moving is also clear.
CIRCULAR LOGIC
Market arguments for strengthening the dollar are based on the idea that Trump tariffs – coupled with stimulative US tax cuts and deportations of migrant workers – will undermine confidence in stricken overseas economies, while boosting US demand and still high inflation is exacerbated.
And in that scenario, the Federal Reserve would not be able to cut its policy rate much further from now on, while other central banks are forced to ease.
This has two important consequences: it underlines a long-standing trend toward US “exceptionalism” as the destination of choice for global investors, and it potentially widens the already large interest rate differential in favor of holding dollars.
Deutsche Bank (ETR:), for example, thinks that the Fed rate will not fall below 4% in this cycle, while the European Central Bank rate will fall to 1.5%. That would leave a final gap of 250 basis points between the two policy rates, compared to current market prices, with a peak of 180 basis points.
And if the final policy mix on taxes and duties becomes more aggressive, the euro-dollar exchange rate will fall below parity – more than 5% below current levels. China, the German bank believes, will also allow the yuan to gradually weaken in that scenario.
The whole conundrum partly explains why some Trump advisers appear eager to put political pressure on the Fed to take an easier monetary stance, even as Treasury Secretary nominee Scott Bessent has backed away from campaign comments about undermining of the central bank with a ‘shadow’ Fed boss. .
But with Fed resistance likely to be high, the dollar is sticking to its script.
$20 BILLION INVESTMENT FLOOD
Although textbooks suggest that yawning U.S. trade gaps should erode a dollar that is already some 10% to 20% overvalued, these deficits have been overwhelmed in recent years by the flood of foreign investment flowing into U.S. assets due to the country’s exceptional economic performance country and the megacap companies.
And after Trump’s election, global investors seem even more convinced that US financial assets are the only game in town right now – that they will only catalyze further dollar appreciation.
America’s net international investment position—essentially the net foreign ownership of U.S. assets—has grown by more than $20 trillion over the past two decades, reaching about $22.5 trillion by mid-year.
Just for context, that investment deficit now amounts to nearly three-quarters of America’s entire annual GDP and plugs the trillion-dollar annual trade gap.
Given these dramatic numbers and frothy valuations, a reckoning may be in the offing. But currency markets have a habit of going to extremes until they encounter a change in rate.
Rather than fueling the boil, higher rates may only exacerbate the problem. Besides being a ploy to get other concessions, they may not even be worth it.
The opinions expressed here are those of the author, a columnist for Reuters
