Part three in a series. Paresh Upadhyaya is Senior Vice President, Director of Currencies, US.
In my previous posts, I discussed the three factors that will fuel the USD rally in 2017: fiscal stimulus proposal (USD Bull Market: Key Drivers in 2017), US rate normalization and idiosyncratic factors (A 2017 USD Bull Market? More Factors to Consider). While the prospects of a stronger rather than weaker USD are asymmetrically greater, two key risks could lead to a divergence in USD performance between G-3 currencies and emerging markets.
1. Changes in US Trade Policy
The US President can unilaterally impose trade sanctions and tariffs. During his campaign, President Trump emphasized free, but fair trade and has explicitly singled out China, threatening 45% tariffs. In addition, there has been discussion on the need to make changes to the North American Free Trade Agreement (NAFTA). We believe the market may be underestimating the prospects of some form of protectionist policies that will have consequences in currency markets.
If we see any form of protectionist trade policies, I anticipate a divergence in USD performance between G-3 and emerging markets. Prior unilateral US presidential actions have led the USD to depreciate versus the euro and Japanese yen (see chart below). In 1993, President Clinton unilaterally imposed tariffs on Japanese auto manufacturers as its trade surplus with the US exceeded 1% of gross domestic product. As a result, USD/JPY plunged 30% from 1993 to 1995. Another notable example was in 2002 when President Bush imposed tariffs on European steel producers for six months and sent the euro sharply higher by 10%. In both cases, the USD depreciated, despite seeing a widening in interest rate differentials in its favor.
Past Effects on the US Dollar of US Presidential Unilateral Actions Source: Credit Agricole. Last data point 12/31/16.
On the other hand, US trade sanctions or tariffs risk a trade war. Emerging market countries dependent on trade will be most vulnerable to weaker growth prospects that will lead to a selloff in their currencies. Overall, emerging market Asian currencies such as South Korean won, New Taiwan dollar, Singapore dollar and Chinese yuan are most vulnerable while potential tweaks to the North American Free Trade Agreement (NAFTA) leave the Mexican peso and Canadian dollar most exposed to a sell off against the USD.
A Trade War Would Leave EM Asian Currencies Vulnerable
Source: Bloomberg and Pioneer Investments. Last data point 12/31/16.
2. G-3 Tapering
Market based measures of inflation expectations have risen sharply. Since the post-Brexit low, US and European inflation expectations have risen 66 basis points and 46 basis points to 1.96% and 1.73%, respectively as of December 9, 2016. With growing signs of global reflationary pressures, the European Central Bank and even the Bank of Japan could begin to taper and start the process to remove excessive accommodative policy. We do not expect this until the second half of 2017 with the European Central Bank likely to move before the Bank of Japan. In anticipation of tapering, interest rate differentials should reverse and move in favor of Europe and Japan, which could mark a turning point in the USD rally against the euro and Japanese yen.
We expect strong fundamental underpinnings behind the rejuvenated USD bull market rally. Easy fiscal policy to boost growth and a corporate tax holiday leading to robust inflows could support the USD. It should also contribute to tighter monetary policy, helping to cement the monetary policy divergence theme. However, the prospects of protectionist policies and G-3 tapering could be turning points for the USD against G-3 currencies.