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BBGFX Update: FX Implications of the Trump Victory

FX Implications of the Trump Victory

The FX market reaction to the Trump victory was just as most had predicted – for a few hours. But by the end of Wednesday the USD weakness that had been seen initially against the majors had evaporated and the USD finished the day higher across the board. It does seem that market predictions that Trump would undermine confidence in the USD and the US economy have been off the mark. Not only is the USD higher, but equity markets have also recovered after an initial sharp dip. The markets are initially giving Trump the benefit of the doubt, and appear to be focusing on the likely impact of his policies rather than any more nebulous concerns about his suitability as a President.

Trump’s economic policies
To some extent the mystery is why the markets thought a Trump victory would be bad for the USD ahead of time. Certainly it had been the case coming into the election that improvements for Trump in the polls had led to the USD weakening against the majors (though strengthening against the MXN), and vice-versa. It seems the main concern was that the equity market would respond badly to a Trump victory because of the uncertainty involved and some analyses suggesting his policies would be bad for growth in the long run, and this would mean less inclination for the Fed to raise rates. But in practice the equity market has, like the USD, rallied sharply after an initial dip. Rather than worry about the uncertainty and long run growth the markets are responding to the prospect of very expansionary fiscal policy.

Tax cuts and infrastructure spending
There is always some uncertainty about how much of a President’s agenda will get through Congress, but in Trump’s case a lot of his policies are similar to the proposals of the House Republicans. There is consequently not much doubt that he will implement a substantial tax cut, though probably much less substantial than the $7trn over 10 years that his plans imply. A big cut to taxes on the low paid and a huge cut in corporation tax both seem to be on the cards. While these could be a problem for the budget in the longer run the effect on the economy in the short run will be to increase growth and push up US yields, and consequently the USD.
There is more doubt as to whether Trump will be able to get his plans for $1trn of infrastructure spending through Congress. The House has rejected similar plans before and although Trump claims that the actual cost to the government will be far less than this due to the structure of his plan involving the private sector, it will probably be bargained down. Nevertheless, it seems clear that there will be a substantial boost to growth (and the structural budget deficit) from a combination of lower taxes and higher spending.

Protectionism – growth negative but trade positive
The other main Trump policy is increased protectionism, tougher trade negotiation and immigration control. This is harder for Congress to oppose except inasmuch as it requires a budget. So while it is far from clear that he will be able to build a wall on the Mexican border, increasing tariffs and even withdrawing from NAFTA are in his power. Any trade restrictions of this sort are likely to mean higher prices and net weaker growth, though some industries will benefit.

Perhaps the biggest uncertainty relates to the geopolitical impact of a Trump victory. His pre-election statements suggested he is happy to have a closer relationship with Russia but that he will back out of the deal with Iran that removes sanctions in return for limits to Iran’s nuclear program. If he does back out of the deal, this could potentially push up the oil price, which could also be affected if global tension increases because of his hostility to Islam.

Global political picture
One other aspect that the FX market needs to take into account is the changing face of global politics which the election of Trump and the UK Brexit decision appear to be symptoms of. The shift towards nationalism and populism and away from the establishment may continue to be seen in the upcoming European elections in France and Germany next year and in the Italian referendum in December. This could potentially weigh on the EUR.

General impact on the USD
Deficit financed fiscal expansion is typically a very positive policy for the currency in the medium term, increasing growth and leading to higher yields both due to higher short term rates and the bond market response to bigger fiscal deficits. This in turn attracts foreign capital inflows. We have already seen a significant rise in bond yields since the election. The last time we had a President with a similar policy agenda to Trump was Reagan, and the impact on the USD was huge. The trade-weighted USD rose 44% from January 1981 when Reagan was elected to its peak in March 1985 (see chart below).
Source: BIS

While Trump may not manage to have quite the impact that Reagan did, the US is already ahead of the rest of the developed world in the cycle and rates have already started to rise. Expansionary fiscal policy and the consequent tighter monetary policy are likely to move yield spreads even further in favor of the USD and give it a boost across the board. The corporate tax cut may also have a direct effect on the USD by encouraging repatriation of profits held abroad by US companies. In summary, the Trump effect looks likely to be significantly positive for the USD in the medium term.
EUR/USD looks likely to be pushed to new 13 year lows in the wake of the Trump victory, below the 1.0463 level seen in March 2015. The timing is uncertain, as clearly policies won’t be enacted for some time, but market anticipation of fiscal expansion could mean things happen earlier than might be expected. Certainly, the Fed is likely to raise rates in December and the anticipation of this and further rate hikes to come could already threaten the lows.
The EUR may also be affected by concerns about repatriation of funds by US companies and probably more importantly by European politics. The Italian referendum on December 4th looks increasingly likely to go against the government in the current anti-establishment mood, and although this doesn’t mean any immediate change in Italy’s position in the EU, it might increase speculation of a referendum on the EUR. The French election next year also looks increasingly dangerous for the established parties. These political factors look likely to weigh on the EUR, and with the ECB still a long way away from even halting QE (never mind raising rates) a EUR/USD move to parity and below can’t be ruled out next year. View graph here.

GBP/USD has up to now been much more affected by Brexit than US developments this year, and has actually shown little net reaction to the Trump victory so far. Nevertheless, we would expect GBP/USD to fall with general USD strength if the market continues to price in Trump’s expansionary fiscal policy agenda. Even so, the downside for GBP/USD should be less pronounced than for other pairs. GBP may benefit from the perceived greater friendliness of Trump to future UK trade deals (even if there is unlikely to be any real action on this in the immediate future), reducing concerns about the impact of Brexit. The advent of Trump may in any case mean the EU is more willing to try and keep the UK onside, potentially helping Brexit terms. If this is the case, and Brexit fears fade, the UK economy is closer to a potential rate hike than the Eurozone or Japan, based on recent performance, and may consequently be dragged along with a strong USD. In the short term Brexit issues may nevertheless continue to dominate, with the UK Supreme Court decision on parliamentary sovereignty due in December, and potentially proving positive for GBP if, as expected, it goes against the government.View graph here.

The CAD reaction to the election has been comparatively restrained, but USD/CAD has net edged higher since the poll. This trend looks likely to continue on the back of the general firmer USD tone based on higher US yields, and the Bank of Canada discussing the possibility of further rate cuts at its October meeting underlines the yield spread widening theme. There is also concern in Canada that the ease of trading with the US may be hampered by a Trump presidency. Nevertheless, if the US grows strongly Canada will benefit more than any other country, so USD strength may be less pronounced against the CAD than some. The CAD will also be influenced by how Trump’s policies affect the oil price. There may be some positive oil price impact from growth and geopolitics, especially if the Iran deal is reversed, but unless a very substantial oil price rise is seen USD/CAD still targets 1.38 near term. View graph here.

USD/MXN had been the market’s barometer of support from Trump going into the election, and it was therefore unsurprising that USD/MXN surged strongly on the Trump victory, and is now up around 13% since the polls closed. However, how USD/MXN performs from now on is far less obvious. Much will depend on how Trump follows through on the various promises/threats he has made. In pure economic terms, USD/MXN is much less at risk from Trump’s policies than other currency pairs. Stronger growth in the US would typically be expected to be supportive for the MXN relative to currencies other than the USD, and even sometimes against the USD with the MXN often behaving as a “super USD” in risk positive times. However, if Trump carries through threats to limit/reverse immigration and lock Mexico out of the benefits of improved US growth the MXN is likely to suffer. But in practice, this seems likely to be more difficult to do than the markets seem to think, and with the MXN already having fallen sharply in recent years, it may represent good value on the crosses here with a lot of the bad political news priced in, but the positive economic outlook not being accounted for. Clearly the USD/MXN trend is up, and is well defined by the 200 day moving average currently at 18.50. It is not a trend to oppose at this stage, but any indication of a softening of Trump’s stance on Mexico may allow a substantial MXN rally. View graph here.

From initially being the biggest beneficiary of USD weakness immediately after the Trump victory became clear, the JPY has become the biggest victim, falling sharply to its lowest level since July. The combination of stronger equity markets and higher US yields is particularly positive for USD/JPY, as BoJ policy effectively fixes 10 year JGB yields at zero, ensuring that any rise in US yields has a full effect on the spread with Japan. In risk positive markets this is particularly effective, and there may consequently be substantial upside for USD/JPY if equities remain strong. However, there are some natural limits on the likely strength of equities if bond yields continue to rise, and if the rise in yield holds back equity strength, it may also to some extent hold back JPY weakness. There is initial resistance for USD/JPY at 1.0750, but a break of this could see gains to test 110 by year end. View graph here.

Compliments of Banockburn – a member of the EACCNY