“You can always count on Americans to do the right thing—after they’ve tried everything else.”
— Winston Churchill (actually Abba Eban in March 1967)
Commentary & Analysis
Trump Triggers a US Dollar Virtuous Circle?
As you well know, markets have reacted very favorably to the recent election of Donald Trump to be the next US President, despite the continued obsessive sniping among the mainstream press and assorted metrosexuals (defined as hubris-filled big city dwellers). Market players are betting on the benefits that might flow to the US economy from the set of tax, regulatory, and fiscal policies Donald Trump has outlined. Interestingly, history at least rhymes here, as we saw an economic boom in America triggered by a very similar set of policies enacted during President Ronald Reagan’s first term in office. The core of Reagan’s economic policy agenda was lower taxes, fewer regulations, and increased defense spending; surprising similar to Mr. Trump’s proposals, albeit articulated differently.
The Reagan Era led to a Virtuous Circle of money flow into America at the time, and it triggered a huge rally in the US dollar and launched the US economy into a real growth trajectory following the inflation prone morbidity of the 70’s. There is a very good chance we could see a repeat under the tutelage of a President Donald Trump. We may again be entering a Virtuous Circle for the US dollar? Let’s take a look at the drivers and potential risks to this scenario which now seems the favored bet…
The chart below compares the US dollar index to the 30-year US benchmark interest rate; I have outlined [rectangular box] the period from 1980-1986 and coined it the Reagan Virtuous Circle for the US dollar. US interest rates soared initially after Reagan was elected, pushing the US into recession (likely volitional as Fed Chairman Volker was determined to crush inflation). Rising interest rates and policy changes triggering fresh new entrepreneurial growth launched the US dollar index into a massive rally phase not witnessed anytime since the major currencies began floating.
The huge rally in the dollar during the early eighties is understandable (in retrospect of course as most things are); when you consider in terms of the three pillars which drive a currency’s value:
We can further breakdown the three pillars into details to see how positive policy changes can trigger growth, rising yield, and money flow. I hope the diagram below will help you better understand why this process can become self-reinforcing…[note I have kept the color-coding: growth related is green, interest rates grey, and money flow blue]…
But there are significant risks to this scenario and I would place the legislative risk number one at the moment. The honeymoon will likely be short for Mr. Trump given the forces aligned against him and the stark policy differences among not only the Democrats, but many within the Republican Party elite. If the tax and regulatory policies do not get enacted, the virtuous circle bet could be quickly reversed. If only some of the policy is enacted or watered-down, the stuff now baked into the cake of asset values will reverse to at least some degree…
Given that market players now seem to have made many one-way bets: long the dollar, long stocks, and long interest rates, my favored scenario is a little shakeout here by Mr. Market, reversing all those trades to some degree, during the transitionary phase where by expectations are realigned with reality and the time it takes for said policy changes to flow into increased corporate profitability and consumer income.
For instance during the transitionary phase: Policy changes will not be enacted immediately. Fiscal stimulus will not be a growth multiplier immediately. The huge debt burden facing developed world nations will not subside immediately and in fact the problem has grown more severe with the run up in the US dollar and surge in interest rates. Friction may develop on the trade policy agenda. And the left will do their best to derail as much of Trump’s legislation as possible. Rising rates and an emboldened Fed will likely reduce liquidity at the margin.
I have already been trying to play for a dollar correction given my expectations for a transitionary phase. Unfortunately my currency ideas have been crushed lately by the runaway freight train (aka the US dollar). Maybe there will be no transitionary phase. Maybe the US dollar Virtuous Circle has started and will not end for some time. Maybe it’s time to capitulate ASAP to this dollar trend and forget about trying to play corrections.
Even if you get the macro right, it’s never easy when playing for real money in highly levered markets. If anyone spots Mr. Hindsight, please send him my way.
[As an aside…here is one bet I think we can make with confidence. If in the months/years ahead, should President Trump’s policy changes lead to a considerable improvement in US economic growth you can bet the Neo-Keynesian crowd will attribute all the success to increased fiscal stimulus. But if Trump’s policy changes are to work, the core driver will come from fresh new business formation triggered by the reduced burden of draconian regulations and taxes on the small- and medium-sized business. Stay tuned.]
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