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OPINION

Dollar doubts

Dollar doubts
November 22, 2016
Dollar doubts

The thinking behind the rise is straightforward and - so far as it goes - reasonable. Traders expect Mr Trump to relax fiscal policy by both cutting taxes and increasing spending on infrastructure. This should boost economic activity which should in strengthen the dollar simply by increasing demand for money and by causing the Fed to raise interest rates.

Some have drawn parallels here with the early years of the Reagan administration. Then looser fiscal policy, combined with the Federal Reserve's determination to raise interest rates, caused the dollar to soar.

Such parallels, however, are probably exaggerated. For one thing, the dollar was cheap when Reagan was elected in a way it isn't today: the inflation-adjusted real exchange rate is more than 20 per cent up from its 2011 lows. And for another, rates might not rise very much. Stephen Gallagher at Société Générale expects the fed funds rate to peak at just 2 per cent. Granted, this would represent a decent yield pick-up against other major currencies. But it's questionable how far traders will want to exploit this, given that we know now that carry trades expose us to considerable crash risk: months of yield pick-up can be wiped out in moments by a sudden currency move.

Fiscal policy, however, isn't the only potential dollar-positive. So too might be Mr Trump's promise to levy tariffs on cheap Chinese imports. You can think of tariffs as an alternative to currency devaluation: both raise the price of imports. In this sense, tariffs reduce the need for the dollar to fall.

Herein, though, lie some dangers for the dollar. It's possible that Mr Trump's policies will damage the economy's productive potential. This would be the case if the benefits of better infrastructure are outweighed by the harm done by protectionism and immigration controls: this would be especially the case if other countries retaliate against US tariffs by imposing their own trade restrictions. Weaker trend US growth should cause the real exchange rate to fall.

You might think this threat would be magnified by the fact that tariffs and a looser fiscal policy will both raise inflation: doesn't purchasing power parity theory tell us that a country with higher inflation should see its exchange rate fall?

It does. But PPP is only true (if at all) in the very long run. It's only a weak reason to expect dollar weakness in coming months.

Perhaps a bigger danger is that the dollar might lose its reserve currency status.

For years, Asian exporters and oil producers have invested their export earnings in dollars and US bonds in the belief that these would be safe: Michael Dooley at the University of California at Santa Cruz has called this the "Bretton Woods II" arrangement.

For this to work, however, dollars must be regarded as safe. A Trump presidency brings this into question, and not just because his aggressive rhetoric raises the low-probability but high-cost threat that he might confiscate some of these assets. The mere election of Mr Trump shows that many Americans are unhappy with the global economic order, and raises the danger that Mr Trump will deliver on his promises to shake up that order. Faced with this risk, why would anyone wanting to hold safe assets want dollars rather than, say, yen or Swiss francs? A yield pick-up of a couple of percentage points might be scant compensation for added uncertainty.

It's possible that the erosion of the US's reserve currency status will more than offset the positive effect of looser fiscal policy.

Now, you'll notice I've used the words "might" and "possible" a lot here. This is because we don't know the details of Mr Trump's actual policies, and nor do we know the market's reaction to them. What we do know, though, is that one worthwhile lesson of the Reagan years is that exchange rates, like stock markets, can be excessively volatile: they can rise too much (as the dollar did in 1985) and fall too far, as it did in 1987.

Yes, it's possible that investors will jump on to the bandwagon of a rising dollar and so cause another bubble. But this is only one risk. The fact is that exchange rates are to a large extent unpredictable. Views on where they are going are too weak to be the basis for an investing strategy. There's a strong case for diversifying into foreign currencies to spread risk. But there's a massive distinction between diversification - which is sensible - and futurology, which isn't.