The dollar - down but not out

“The report of my death was an exaggeration” – Mark Twain

“I would rather see Finance less proud and Industry more content" – Winston Churchill

At the start of the year the dollar was riding high on the back of the Trump trade. One measure of its all-round performance had reached record levels, and tariffs were widely expected to push it still higher.

In the event, it weakened, particularly against European currencies. By this week that trade-weighted index had fallen by around 5%, while the cross rates against the euro and Swiss Franc were both down by around 12% (at which point the euro is back at early 2022 levels, while the franc has only been higher once before, during the franc’s 'safe haven' spike during 2011’s nascent euro debt crisis).

There have been many tentative reversals in the dollar in the last decade, but in each case they proved short-lived. A bigger trade-weighted slide came after Trump’s first inauguration: it went on to last for just over a year before the dollar resumed its upward drift.

However, the rhetoric accompanying Trump 2.0 feels slightly different in one respect at least. The focus on trade and tariffs is bigger and louder now, and Trump and his circle have declared more clearly for a weaker dollar – so much so that some of his circle have encouraged global investors to reconsider its reserve currency status. For their part, those investors have needed little encouragement to question the new administration’s credibility – again, more so than in 2017. Pundits are eager to talk (not for the first time) of the dollar’s demise, and of a new world order.

It is not clear how committed Trump is to a weaker dollar. The wider MAGA project seems intent on prescribing a host of misguided treatments for a misdiagnosed illness, and its inconsistencies and harmful side effects may hurt his poll ratings. Even if he is committed to a lasting depreciation, it is not clear how best he can deliver it: there are two sides to the market, and the dollar will only stay down if both would-be sellers and buyers think it should do.

Mr Trump could, if really determined, seize control of the Federal Reserve and flood the market with dollars, but the resultant financial mayhem would make Liberation Day look like a stroll in the park. Otherwise, he has to rely on market forces – and talk – to bring about the weakness he seeks.

Those market forces working through the existing trade deficit are clearly not up the job, otherwise the dollar would have been trending lower, not higher, in recent years – and a smaller deficit would reduce net dollar sales, not add to them. So if markets are to do Mr Trump’s job for him, he must somehow discourage capital inflows, and encourage existing investors to sell their US assets – and there’s still a hole in the bucket, Dear Liza: if America is going to be considered Great Again (as we’ve noted elsewhere, in the world of finance it has never not been great) then the dollar will be bid higher, not offered lower.

If this all sounds muddled, that’s because it is. Trade deficits are not necessarily a problem for a diversified, wealthy economy, and they are not usually caused by exchange rates to begin with (the world has likely changed since Churchill’s quote). Similarly, presiding over the world’s favourite reserve currency – and being able to borrow as yet unlimited amounts in your own currency – may not be such a bad thing. Again, misguided treatments for a misdiagnosed problem.

Meanwhile, everyone’s favourite candidate for the next reserve currency – China’s renminbi – is unlikely to supplant the dollar any time soon. As we have noted often, this is largely a matter of logistics, not prediction.

For a currency to be a widely-held reserve asset requires that the rest of the world holds lots of it – but China has capital controls and a structural balance of payments surplus. Whatever the renminbi advocates say, more widespread invoicing in China’s currency can do little in the face of these constraints. And if/when those remaining capital controls come off, we think we know in which direction the net flows will be heading, at least initially.

So is China’s ring-fenced currency being manipulated, as Trump says? It is certainly cheap in absolute terms: to equalise prices in China’s economy with those in the US – to reach 'purchasing power parity' – there would need to be just half as many renminbi to the dollar as there are currently, judging by IMF estimates in the latest World Economic Outlook. But 'manipulation' suggests a deliberate fine-tuning, rather than the natural result of allowing an underdeveloped and still largely closed economy to join the world trading system.

China is big, but even now still relatively poor on a per capita basis, and its catastrophic twentieth century experiences likely leave its government understandably cautious. That said, the commercial playing field is currently tilted in their favour – Trump has a point here, remember.

So where next? Currency calls have not recently been a big part of our investment process, though this could change. The problem is that conviction is scarce at the best of times (or it should be: exchange rates are among the most over-analysed prices in capital markets). Most portfolio returns anyway are usually dominated by local stock prices, not exchange rates.

The dollar looked dear (in real terms) in January, but not outlandishly so, and it is a little less expensive now. Meanwhile, Europe in particular still has economic – and governance – issues of its own. As noted, we think there are many strategic loose ends in the current debate, and we can’t quite believe that US financial credibility is permanently impaired (yet).

But we are no more than indifferent tactically. From our top-down perspective we no longer find US stocks especially attractive, and if we felt the dollar were suddenly about to rebound and surge anew we would likely be more positive there. The current show is not over, and while it’s playing you don’t heckle the man with the microphone.

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