King dollar shows no sign of abdicating

The US dollar has strengthened by almost 4% against the euro so far this year, and in a matter of days last week it gained 1.6% against the yen.

A few factors suggest that this is primarily being driven by a flight to quality. The coronavirus certainly appears to be playing some role, amid the likelihood of a prolonged shutdown in China and outbreaks developing in other countries.

US politics may also have contributed to the risk aversion. Michael Bloomberg’s difficult first TV debate was viewed as boosting the odds of Bernie Sanders becoming the Democrat party’s candidate. A Sanders presidency may not be the market’s preferred outcome, but current pricing seems to have interpreted a possible Sanders nomination as increasing the chances that President Trump wins re-election.

We should not overstate the dollar’s rally, though. So far, on a trade-weighted basis the dollar is only up by around 2.5% this year. This is still well within the range of the past five years.

Yet if the dollar keeps moving higher, there are a few potential checks on its climb. One of the most obvious is that the president could tweet about the dollar being too strong; he has decried other countries’ supposed manipulation of their currencies in the past.

A more worrying possibility would be if Trump lashes out again through his trade powers: the Department of Commerce has enhanced powers to impose countervailing duties on unfair currency subsidies. This is designed for specific products, though, and I believe the mechanism likely requires the US Treasury to label a country a currency manipulator before these tariffs can be imposed.

Inflation FX

Another consideration is whether a more ‘expensive’ dollar suppresses US inflation, such as by making imports cheaper, and so makes it easier for the Federal Reserve (Fed) to cut interest rates.

US inflation is not particularly sensitive to the exchange rate, however. A 10% appreciation of the dollar would reduce core goods prices by around 1%, and these only have a weight of around 25% in the core inflation measure. The move in the dollar so far should therefore have a negligible effect on inflation.

A more important element has been the general easing of financial conditions as long-term interest rates have fallen sharply. This has more than offset the small appreciation of the dollar and is a major reason why we have upgraded our baseline forecast for US economic growth in the second half of the year.

Of course, this all assumes that the coronavirus is contained. In mid-February we saw the flash US composite output index slump to a 76-month low of 49.6, down from 53.3 in January. The month’s flash US manufacturing purchasing managers’ index similarly slipped from 51.9 in January to 50.8, a six-month low. This gave us our first glance of the potential damage if the virus continues to disrupt the economy.

Fed speakers nevertheless generally downplayed the prospects of a rate cut last week. James Bullard perhaps summed up the thinking best: “Markets are pricing in an interest-rate cut this year by averaging the most likely outcome from the coronavirus – little damage to the US economy with a remote chance of a serious and long-lasting impact.”