Fundamental Comment

Can the U.S. dollar make a recovery in 2018?

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2017 was an incredible year for USA equity markets, the DJIA and tech heavy NASDAQ indices rose by circa 30%, with certain FAANG stocks (Facebook, Amazon, Apple, Google and Netflix) rising by approx. 50%. Improved corporate earnings, especially in the banking and financial sector, helped place a rocket under prices, as did the confidence a Republican administration generates; they are by nature always more favorable towards big business. However, without a doubt, the main reason equities experienced such stellar returns during the year was due to Trump’s promise to reduce the highest level of corporate tax from 35% to 21%. Despite the fact very few large corps pay such a level of tax, analysts and investors quickly crunched the numbers and revised their valuations for many leading quoted USA companies.

Whilst equities rose the dollar fell versus many of its major peers during 2017, and this was despite the Fed sticking to its commitment to raise interest rates three times during the year, with the key interest rate now at 1.5%, one percent higher than the U.K. and a full 1.5% higher than the Eurozone. Despite the FOMC rate rises the dollar fell as a consequence of two main issues. Firstly; Trump’s administration promised a massive fiscal stimulus to repair the USA crumbling infrastructure, with an estimated cost of over one trillion USD this cost would be government spend. Secondly; the reduction in tax would cost approximately $1.5 trillion over the next decade, therefore forex analysts quickly crunched the numbers and realized that Trump was punching a potential hole of $2.5 trillion in the USA govt finances over the next decade or so.

Arguments were put forward that the tax loss shouldn’t be regarded as zero sum; less tax should mean more investment by corps and more money in U.S. citizens’ pockets to spend, therefore some analysis suggested the impact might be neutral on taxes, or positive. But these two issues caused the dollar to fall, defying the conventional wisdom that three interest rate rises would cause a rotation out of equities, into the safer haven of the USD.

At the start of 2018 many analysts are already (tentatively) suggesting that 2018 may be the year the dollar recovers, some cite that the dollar is too low, which is making imports more expensive which could lead to a spike in inflation, therefore the Fed/FOMC should get ahead of the curve and raise rates as early as possible in 2018. Others will state that the USA administration is entirely comfortable with a low dollar, as it assists manufacturers and exporters, two key sectors Trump declared support for during his 2016 election campaign.

The three rate rises, conducted by the FOMC during 2017, were not agreed close on unanimously by the committee, in order to defend the dollar. In fact, within the written commentaries accompanying the rate rises, there was little reference to the value of the dollar versus its main peers. The main considerations appeared to be getting inflation up which has lagged, despite the punch bowl of quantitative easing being withdrawn from 2015 onwards. Therefore a low dollar, possibly increasing inflation as imports increase, may have been an unwritten objective of the Fed/FOMC.

The Fed/FOMC have suggested that they have a target to raise rates three times in 2018, to begin a normalization process. These rises could take the interest rate to 2.25% by the end of the year. If that level of rate doesn’t stimulate dollar growth by the year’s end, versus the euro and sterling, currencies that are underpinned by central bank rates of 0.00% and 0.5% respectively, then the realization may emerge that the USA economy and the value of the dollar has entered unchartered, or off the chart territory.

Research and Content credit: FXCC

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