The two main drivers of the recent recovery of US financial asset prices are obvious, I guess.
First, the random tariff generator has shifted back to tariff light, in a way that is colorfully characterized by former Press Secretary Anthony Scaramucci. My own attempt at a value added here would be just to point out that aggressive tariffs = the need for — and therefore near inevitability of — weak growth. And it is never really “too late” to do the less wrong thing and improve the growth outlook. True, persisting uncertainty is steadily undermining the economy’s cyclical momentum, with effects that will linger, as is emphasized by economy bears. And that may explain why bond yields have ended up lower here, even with the short to medium term inflation path having tilted at least slightly higher. But a lesser inflation pulse and thus reduced risk of recession will always beat a high pulse and greater recession risk. And even if recession becomes likely, a shallow one is better than a deep one. In any event, the economy does not seem prone to recession if left unmolested.
Second, there is apparently no real plan afoot to fire Fed Chair Powell and replace him with someone less averse to an inflation policy. Rather, Powell has been identified as the fall guy to blame things on if stupid federal government policy pushes the US economy into recession.
In this note, I want to update my take on the role of the dollar in this episode, because it is something I have been following a bit more closely in recent months, and because I have a perspective here that is some ways differentiated. I have been pushing three points:
- America’s external payments imbalances have recently become large enough to matter to investors, although there is no reason for them to be the target of policy, as they should tend to be self-correcting.[1]
- The idea that US capital had recently begun to pull out of the US is simply factually wrong, but not in a way that should give us any sense of relief. If the current account deficit is widening, then the net capital inflow will be accelerating. And asset prices will adjust to make sure that the capital is attracted in. Only later, do those changes of asset prices affect the current account.
- If the desired capital inflow is insufficient to finance the large and still widening current account deficit, then US asset prices must cheapen relative to foreign asset prices. But the US is a large and largely closed economy, so this cheapening should be achieved more by the currency and less by fixed income, if the issue is simply a balance of payment constraint. If there are separate risk off elements in the picture, then that will complicate things, but as a general point balance of payments dynamics are not likely to set Treasury yields or even the slope of the yield curve.
Dollar is slightly off its highs, though up marginally in past couple weeks
Source: Federal Reserve, Bloomberg, FH calculations
Index is expressed monthly. It is effectively actual to April 16 and fairly precisely estimated to around the equity market open this morning.
One sort of interesting thing about the foreign exchange value of the dollar is that the commentariat have an extremely strong tendency to overstate its general movement. This can often be achieved by citing DXY, which is a quite narrow index that ends up being basically the euro inverted. The Fed’s broad trade-weighted dollar index peaked a couple weeks after the inauguration and fell just over 5% from its peak through April 16, which is the last date for which the Fed has published its index. That index is easily proxied, and in the chart above I show a long history of the real broad trade weighted dollar updated through this morning. And the update reflects a very slight strengthening of the dollar since April 16, perhaps because the effects of not dumping Powell and encouraging domestic risk on have trumped the effects of tariff de-escalation, which in isolation, might have been expected to weaken the dollar. There have been a lot of things going on.
Looking forward, there are perhaps a couple things worth pointing out. First, as is probably now well understood, the idea that a stronger dollar might help offset the inflationary effects of the tariffs is probably a no hoper. The way to avoid damage from the tariffs is not to do aggressive tariffs – or any at all, ideally.
Second, it is hard to say that there is an inflation or rule-of-law discount in the foreign exchange value of the dollar. The dollar is still fairly high, at a time when the current account is large and inclined to widen further if the premise of US demand growth outperformance (embedded in yield advantage) is sustained. For the dollar, this is an awkward starting point, which means that the main risks around the currency are probably skewed to the left. But it does not follow from this that the dollar – or even balance of payments dynamics influencing it – are a significant threat to domestic asset prices.
[1] It is sometimes pointed out that the current account deficit may reflect the large fiscal deficit which may itself be a problem. There is probably something to that, but it does not justify targeting the current account balance. Separately, and operating in the opposite direction, I would not place much weigh on the idea that the US can run a large trade deficit because of our advantage as international investors, as argued – along with less dubious points — here. The US current account balance incorporates those returns to our superior investing skills and it is larger than the net exports deficit, with the difference there have recently switches signs, the wrong way. One can believe that the current account deficit is not a problem while still recognizing that it has become large enough to matter for capital markets.
