Rampant US dollar sends a threatening message to the rest of the world

The US dollar has been on a tear since the US election, sending waves through currency and commodity markets in a warning of what might be in store for the global economy.

Since the election and the Republican trifecta – control of the White House, Senate and, it seems, near-certain control of the House – the greenback has appreciated 3 per cent against the basket of its major trading partners’ currencies. It’s now at its highest level in two years.

It’s up 3 per cent against the Australian dollar, 3.5 per cent against the euro, 2.5 per cent against the Japanese yen and nearly 2 per cent against China’s tightly managed yuan.

Donald Trump’s ultra-loose fiscal policy has put a rocket under the US dollar.Credit: AP

Oil prices are down nearly 5 per cent, gold is down almost 8 per cent and copper has lost 9 per cent.

The explanation for the US dollar’s post-election surge is straightforward. The markets are responding to Donald Trump’s economic agenda, with its punitive tariffs on all imports (and especially on those from China), his proposed massive tax cuts and his plan to round up and deport millions of illegal immigrants.

The plan constitutes ultra-loose fiscal policy, and compared with current policy settings is adding an estimated $US7.75 trillion ($12 trillion) to US deficits and the existing $US35.5 trillion of government debt.

The threat posed by the strength of the US dollar is particularly acute for emerging economies, but even advanced economies can be buffeted.

The tax cuts would boost America’s already strong economic growth. At the same time, the tariffs and the shrunken pool of labour, if the deportation policies are implemented, would be inflationary.

Where financial markets had been pricing in another 25-basis-point rate cut by the Federal Reserve Board next month (which they might still get) and at least three more next year, they now have to re-evaluate their expectations.

If US inflation takes off again in the second half of next year, rates will rise, not fall.

Trump’s tariffs would shrink global trade volumes and cause falls in the currencies of tariff-affected exporting countries to offset the increased price of the exported goods in US dollars – strengthening the US dollar’s value in the process.

The trade-induced effects would be exaggerated by any tightening of US monetary policy and increase in US interest rates in response to the deficit-funded boost to growth, the increased cost of goods to consumers resulting from the tariffs, and the higher labour costs driven by the smaller workforce as huge numbers of low-cost migrant workers are deported.

The combination of Trump’s policies would export inflation (via currency depreciation) and financial instability to the rest of the world.

Depreciation makes exports more competitive and would help blunt some of the impact of Trump’s tariffs, but it makes imports more expensive, creating inflationary pressures that could force a general rise in global interest rates.

For those countries that have borrowed heavily in US dollars, mainly emerging economies, it makes servicing and repaying their debt more expensive.

A strengthening US dollar/depreciating local currency also promotes capital outflows – capital flows towards the higher interest rates and currency appreciation in the US – while adding to the depressing effect of the tariffs on global growth.

The threat posed by the strength of the US dollar is particularly acute for emerging economies, but even advanced economies can be buffeted.

Senior Japanese financial officials are referring to the yen’s depreciation as “drastic”, saying they are watching the developments “with utmost urgency” and ready to take action – intervention in the market to support the yen, or higher interest rates, or both – if required.

The prospect of a trade war and potential retaliation by major economies like China and the European Union adds to the global anxiety over the implications of Trump’s resounding win.

The falls in the oil and copper prices reflect the concern about the global growth outlook. Less growth, particularly within an already weakened China, the primary target for Trump’s trade policies, means less demand for oil and commodities, such as iron ore.

If China, the main driver of global growth in recent decades, ever implements the much-discussed fiscal “bazooka” to lift domestic consumption levels, it might soften the impact of a new trade war. However, its economic growth – already weakening – would still be less than it might have been without new trade hostilities.

The fall in the gold price, which had been on a massive run of its own ahead of the election, is a direct response to the rise in the US dollar and expectations of higher US interest rates next year. Gold generates no income, so there is logic to a switch to rising US bond yields, even if gold has historically been seen as a hedge against inflation.

Trump has vacillated when talking about the US dollar. Sometimes he says he wants it lower to make US exports more competitive, and at other times he says he wants it strong as a signal of US economic strength.

Indeed, in response to the talk about “de-dollarisation”, he has threatened to impose tariffs of 100 per cent on countries that shun the dollar – even as some of his advisers, concerned that the dollar’s strength could expand the US trade deficit, discuss ways to force a depreciation, including pressuring other countries to take action to strengthen their currencies.

A manufactured weakening of the US dollar would have its own consequences, adding to US inflation, jeopardising the dollar’s positioning as the world’s reserve currency and the dominant currency in global trade and finance, and undermining America’s ability to use that dominance to enforce sanctions.

The seeds of the notion that the US could coerce its major trading partners into artificial currency appreciations at the centre of the Trump advisers’ thinking – while threatening its major trading partners with a trade war – lie in the 1985 Plaza Accord, where the threat of tariffs helped convince Britain, Germany, France and Japan to intervene in foreign exchange markets to steadily force an overvalued dollar down.

The strengthening of the yen post-accord played a role in Japan’s decades of economic winter, beginning in the late 1980s, and the country’s broader trepidation about the implications of a second Trump term.

Given that experience, it is unlikely that US trade partners would be keen to co-operate and surrender to coercion from an administration not regarded as a supportive ally.

It is conceivable that the dollar’s strengthening will continue until the consequences of America’s fiscal profligacy – turbocharged by Trump’s agenda – either come home to roost and the US economy is forced into recession by the Fed and the dollar slumps, or - if Trump gains influence and control over the Fed - US monetary policies lose all credibility and foreign capital flees.

Either outcome would be messy and destructive for the US and the rest of the world.

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