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Weakening Dollar Sends Warning on US Economy

Some but probably less than half of the dollar’s weakness can be explained by higher than expected inflation in the US
Over the past year, the US dollar has fallen by close to 10% on a trade weighted basis and by more than 10% against the euro.Over the past year, the US dollar has fallen by close to 10% on a trade weighted basis and by more than 10% against the euro.

The US currency slipped from its six-week high that it touched on March 1, after US President Donald Trump announced plans to levy hefty tariffs on aluminum and steel imports igniting fears of retaliation from its trade partners.

“Any escalation of trade wars will significantly dent the US dollar appeal, weigh negatively on US assets such as bond and equities and make gold the go-to hedge against rising US fiscal and political vulnerabilities,” Stephen Innes, APAC trading head at OANDA, said in a note Monday, news outlets reported.

One of the many surprising aspects of financial market performance over the past year has been the weak performance of the US dollar, which has fallen by close to 10% on a trade weighted basis and by more than 10% against the euro.

This has occurred despite a variety of factors that might have been expected to push the dollar up. They include upwards revisions in economic forecasts, expectation of monetary tightening, rising real and nominal long-term interest rates, fiscal stimulus on a huge scale in a full employment economy, rising protectionism that should choke off import flows, and tax reform directed at reducing capital outflows and increasing capital inflows.

It is instructive to consider what the combination of interest rates and current exchange rates says about market expectations of future currency values. US 10-year interest rates are about 230 basis points above German rates and about 280bp above Japanese rates.

Markets Expect Dollar Depreciation

This implies that markets expect depreciation of the dollar by more than 25% against its major competitors over the next decade. If dollar depreciation of this magnitude was not expected, investors would prefer dollar assets to foreign assets, given the interest rate differentials. Some but probably less than half of the dollar’s weakness can be explained by higher than expected inflation in the US. Real interest rates imply an expectation of continuing real depreciation.

Given the movements in interest rates in the past year along with the dollar’s fall it is reasonable to estimate that expectations of exchange rates of the dollar against the euro 10 years from now have fallen by perhaps 15%. Information on real yields suggests that much of this move reflects expected declines in real exchange rates.

To the extent that dollar weakness reflects disproportionate improvement abroad, it undercuts claims that US policy is the reason for recent strong performance since Trump is not president of the whole world.

But this is only a partial explanation. If it were the dominant story one would expect to see rates in other countries rise more than in the US as they experienced larger increases in demand for investment funds. This has not for the most part happened.

Anxiety Rises

The pattern of higher interest rates and a weakening currency suggests that on multiple dimensions US assets now have to be put on sale to convince foreigners to hold them or induce Americans not to diversify into overseas assets. This pattern is relatively uncommon in the US though it happened in the Carter administration before Paul Volcker’s appointment as chair of the Federal Reserve and in the Clinton administration before treasury secretary Robert Rubin’s invocation of the “strong dollar” policy. It is fairly ubiquitous in emerging markets where it reflects anxiety over a country’s policy framework.

Fear of such anxiety may be emerging in the US. Trump and Treasury Secretary Steven Mnuchin show their ambivalence about a strong currency. Washington consciously takes budget deficits way up in a full-employment economy. Questions arise with respect to the Fed’s independence, America’s traditional receptivity to foreign investment and its willingness to lash out at holders of dollar assets.

These concerns are greatly magnified by the decision last week to impose across the board tariffs on steel and aluminum.  The fact that declines in the aggregate US stock markets were about 100 times as much as the gains for steel and aluminum companies illustrates that because the steel using sector dwarfs the steel producing sector, the net effect of the tariff policy is to reduce US competitiveness even before considering foreign retaliation.

And then there is the risk that a president who likes trade wars will have more of them.

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