Millennium’s Dissaux: Currencies will play a key role amidst a Trump economic agenda

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Political risks are difficult to trade and binary election outcomes are not events that fund managers typically want to bet on.

But when an unforeseen event such as the outcome of a US election acts as a catalyst to accelerate economic trends, trading opportunities arise.

Even before the US election there was a stark differentiation in inflation dynamics between the US and the Euro area and Japan, which had yet to be priced in currency markets. It is striking that although GDP growth in the US may be similar to the Euro area in 2016 at around 1.5 per cent, underlying inflation in the Euro area remains stuck below 1 per cent while moving gradually towards the target in the US.

Trump’s plan for a large fiscal stimulus, at a stage when the US labour market is close to full employment, will only reinforce this differentiated position and signal an end to a persistent under-pricing of market expectations compared to the Fed’s expected path for interest rates.

According to our estimates, the USD index versus advanced economies was about 5 per cent cheap compared to rate differentials before the election. A reconnection of this relationship points to a further rise of the USD versus EUR and JPY. Promises of tax measures to encourage corporates to repatriate foreign earnings only add to this positive USD momentum.

However, the road to a stronger USD is set to be a bumpy one, not least because of the unprecedented uncertainty surrounding broad economic policy of the new US administration. Shifts in the policy mix may not be smooth amid a rise in populism.

With years of unconventional monetary policy failing to return growth and inflation to pre-crisis levels, criticism by governments of quantitative easing and exceptionally low rates has grown, be it in Germany or the UK. This could well be repeated in the US and is bound to bring more currency volatility.

While the Fed is independent and Chair Yellen’s mandate ends only on 3 February 2018, Trump’s past criticism of the Fed suggests that he may quickly fill the current two vacancies and nominate a candidate for the Chair position as soon as the second half of 2017, which could lead to a less dovish FOMC in the year ahead.

But candidate Trump also called for legislation to be enacted that would allow for an audit of the Fed’s policy decisions, which would be seen as a threat to the Fed’s independence, a potential negative for the USD.

It also cannot be ruled out that President Trump translates part of his rhetoric on trade and immigration into action in his first few months in office, which could shock markets that have so far focused solely on the fiscal boost.

Higher tariffs imposed on China would prompt retaliation and spill over to other economies, bringing higher inflation to the US consumer and dealing a serious blow to US trade, investment and growth. In such an environment, the USD would rise against a number of emerging market currencies, especially in Asia, but fall versus safe haven currencies such as the JPY, and EUR; a very different outcome from a cyclical push for the USD.

The feedback loop from the rise in US yields and stronger USD to the economy should provide another source of volatility in 2017. There will be a tipping point when higher mortgage rates and tighter credit conditions do the job for the Fed. As a result, while financial market volatility has so far been much lower than anticipated under a Trump win, this could change abruptly.

A key investor question for 2017 will be whether the US economy can escape the slow growth, poor productivity, low interest rate equilibrium it has been stuck in over recent years and extend the upward USD cycle. US fiscal stimulus will need to be well-targeted and structural reforms delivered for US potential growth and productivity to be propelled higher.

Global investors should take note that as a cyclical push meets structural constraints, including government debt sustainability, an overextended credit cycle and dwindling monetary policy ammunition, currencies will likely be a key variable of adjustment.

Claire Dissaux is head of global economics and strategy of London-based Millennium Global Investments.