The consensus on a strong dollar may be too complacent

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Author of Two Hundred Years of Modeling Through: The Surprising Story of the British Economy.

A common thread running through the forward outlook to 2025 from banks and asset managers was a near-unanimous view that the dollar will strengthen over the next 12 months. As with so much else on the incoming Trump administration’s agenda, discussions around the value of the greenback have been contradictory at times.

Donald Trump himself, along with many of his top trade policy advisers, has long argued that a strong dollar has made American exports more expensive, encouraged imports and cost American manufacturing jobs. Others in key jobs, however, like Treasury Secretary nominee Scott Besant, have publicly taken a more traditional stance and supported a stronger dollar.

Whatever the new administration’s intentions, markets seem reasonably certain that the result will be a stronger dollar rather than a weaker dollar. The dollar has gained about 8 percent since late September as investors bid up prices on the growing prospect of a Trump victory in November. A strong dollar was a key element of the Trump trade that gripped Wall Street last year. Broadly speaking, the Trump trade is an assumption that the new president will pursue all aspects of his agenda that the markets approve of, while his larger counterparts refrain from anything they are less interested in.

Tax cuts and deregulation will boost profits and equity market returns while the resulting higher deficit is bad for the US Treasury, but not catastrophic. Markets expect U.S. government bond yields to rise relative to a no-Trump counterfactual but implicitly anticipate that the rise will not be enough to upset the stock market. Rising interest rate differentials with other advanced economies, however, would be enough to push the dollar higher, according to Trump trade logic. The threat of higher tariffs, which would lead to fewer dollars leaving the US, added to the dollar’s luster since November.

The consensus view, then, is that the dollar will remain strong despite the occasional shout-out on social media by the new president. There are at least three reasons to think, however, that this consensus is complacent.

Customs first. Economic theory suggests that in the short term new tariffs may actually lead to a stronger currency. Trading partners’ currencies subject to new restrictions often depreciate to offset, at least in part, the value of tariffs. This was largely the case with China’s renminbi in 2018-19. But in the long run tariffs are associated with lower imports and exports and an overall weaker economy. That weakness ultimately leads to lower interest rates and therefore a weaker currency. Tariffs may give the dollar a short-term lift but weaken it over the medium to long term.

Second, it should be seriously considered that when Trump says he wants a weaker dollar, he actually means it. The threat of much higher tariffs on America’s major trading partners may well prove to be merely the opening gambit in an effort to force those trading partners into some kind of multilateral agreement to devalue the dollar. There is little doubt that the author The Art of the Deal Wouldn’t be happy to host a summit at Mar-a-Lago to preside over the discussion. Of course, the mechanics of such a deal would prove tricky. The Plaza Accord of 1985, in which the finance ministers of the United States, the United Kingdom, West Germany, France, and Japan met to negotiate international exchange rates, is sometimes held up as a model. But the global economy is a very different place these days. 40 years ago the five participants represented about 45 percent of global GDP at purchasing power parity, compared to 25 percent of them today.

Other major threats to the value of the dollar can be found outside the traditional realm of economic policy. work by economists Barry EichengreenArnaud Mehl and Livia Chitu examine the geopolitical underpinnings of international currency values ​​in 2017. In general, countries hold a large portion of their reserves in the currency of a country that provides them with a security guarantee. By this logic the US providing security to its allies helps maintain the value of the dollar and keeps the cost of US debt lower than it would otherwise be. If those safety guarantees begin to falter, the dollar’s share of international reserves could begin to decline, providing further headwinds.

The dollar has strengthened since September but many opinions based on those gains may turn out to be wishful thinking.