By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
The Trump rally is disappearing. Since the beginning of the year, the U.S. dollar index is down close to 3% and while the S&P 500 is still up for the year, the Dow is turning negative. Additionally, ten-year Treasury yields have fallen sharply, dropping as much as 8bp at the start of Donald Trump’s first week in office. It is clear that Trump’s policies are making investors nervous, but protectionism can be good for the dollar. On Monday morning, President Trump reiterated his plans to “cut taxes massively” and bring manufacturing jobs back to America. These comments initially helped the greenback recover overnight losses but the gains were given up quickly as market participants chose to focus on his plan to “impose a very major border tax.” While Trump is following through with his promise for tax cuts, spending and jobs, it is becoming clear that it will be at the expense of international trade. We shouldn’t be surprised as this is consistent with his assaults on China and Mexico for their role in weakening U.S. trade and his criticism of a strong dollar. Protectionism was also a big theme of his campaign and now it is clear that he will be pressing forward and not retreating from these promises. He made 3 official announcements Monday: #1 Withdraw from TPP, #2 Freeze federal hiring except military and #3 Reinstate Mexico City rule banning US funds supporting overseas abortion. According to Press Secretary Spicer, there may be more executive orders on trade this week that will undoubtedly trigger more volatility in currencies.
In order to pay for corporate and individual tax cuts, Trump needs a border tax, which on a fundamental basis is negative for U.S. stocks and positive for the dollar. More than 40% of the sales of companies in the S&P 500 is out of the U.S. and an even greater number produce parts of their product abroad. While goal is to increase the tax revenue, inflation would rise, imports would fall and exports would increase. The U.S. dollar should benefit from a border tax even though it is now falling on risk aversion and uncertainty. All signs are pointing to a global trade war. The Mexican government said Monday that it is “obliged to take steps to defend their interests given the new vision in the U.S.” Investors are worried that other countries will retaliate and any headlines related to that would be USD negative. In other words, before the dust settles, the dollar could and should continue to weaken against many major currencies before a border tax finally lifts it again. It is estimated that a 20% border tax would boost the dollar by 15% over a 3-year period because it effectively devalues the dollar by making imports more expensive and exports cheaper. Of course, how much the tax affects the dollar ultimately depends on how many industries and countries are subjected to the tax. With no major U.S. economic reports scheduled for release before Friday when Q4 GDP numbers are due, Trump headlines will continue to drive greenback flows. As for USD/JPY, if it remains below 113, there’s a good chance we’ll see 112 tested.
Next to the Japanese yen, Monday's best-performing currency was the British pound, which broke 1.25 versus the U.S. dollar. Sterling is a big focus this week with the U.K. Supreme Court’s ruling on Article 50 due on Tuesday. The British pound performed extremely well Monday as it is almost certain the Court will vote in favor of Parliament’s approval in triggering article 50, which would spark another near-term spike in GBP. However if we are wrong and they say no approval is needed, sterling could slip quickly. Aside from the U.K. Court’s decision, we are also watching for any interesting headlines from Prime Minister May’s trip to Washington. If the U.S. throws its support behind a strong bilateral trade deal with the U.K. (and we think it will), sterling will trade sharply higher on the hope that other nations will follow. Before her trip, however, we have Q4 GDP numbers and a speech from Governor Carney on the calendar.
The euro also extended its gains versus the greenback but had difficulty breaking above 1.0750. Part of the move can be attributed to the sharp drop in German bund yields and EUR/GBP selling. The Eurozone’s January PMI reports are scheduled for release Tuesday morning and while the drop in German industrial production and factory orders point to lower activity, the weaker euro may have offset some of that pain. Either way, we believe it's only a matter time before EUR/USD makes a run for 1.08 and that move will be driven primarily by U.S. dollar weakness.
All three of the commodity currencies traded higher versus the U.S. dollar on Monday. While the New Zealand dollar was the biggest gainer, the Canadian dollar experienced the greatest intraday volatility. Having traded as high as 1.3335, the currency pair ended the day near 1.3250. Wholesale sales rose less than expected but oil prices recovered part of its earlier losses. According to OPEC, members are on track to reach their production-cut goals. AUD and NZD benefitted from the drop in the U.S. dollar but the recent drop in iron ore prices held AUD back. Gold prices, on the other hand, continued to move upwards. New Zealand’s PMI manufacturing report was scheduled for release Monday evening but the main focus this week for the comm dollars will be on inflation as we expect divergent price pressures in Australia and New Zealand. Higher commodity prices and consumer inflation expectations should have driven Australian CPI upwards but lower dairy and food prices in New Zealand should keep NZ CPI under pressure.