A softer dollar has probably contributed to a rampaging stock market. The question for investors—and the Trump administration—is whether that will continue to be case now that Washington appears to have fully embraced dollar weakness as a trade-policy tool.
“If equities like a weak USD (U.S. dollar) then there is a good chance U.S. policy makers will like a weak/weaker USD, too. The same holds true for trade policy,” said Alan Ruskin, macro strategist at Deutsche Bank, in a Wednesday note.
U.S. Treasury Secretary Steven Mnuchin on Wednesday told reporters at the World Economic Forum’s annual meeting in Davos, Switzerland, that a weaker dollar “is good for us as it relates to trade and opportunities.”
The remarks, coming alongside a ramping up of trade rhetoric by other Trump administration officials and the decision earlier this week by Washington to slap tariffs on imports of solar panels and washing machines, prompting worries of a potential trade war with South Korea and China.
The dollar suffered through 2017 and has continued its slide in the new year. The ICE U.S. dollar index
a measure of the U.S. unit against a basket of six major rivals, fell nearly 10% in 2017 while the S&P 500
advanced 19.4%. The dollar index is off 3.2% so far in January, while the S&P 500 is up more than 6%.
A weaker dollar is often viewed as positive for U.S. equities, particularly multinationals who sell goods overseas. They also make U.S. assets cheaper to foreign buyers. Ruskin recalled a 2015 speech by former Fed Vice Chairman Stanley Fischer, in which he noted that the Fed trade model shows a 10% fall in the trade-weighted dollar index can boost real exports by 7% over three years and contribute 1.5% to gross domestic product if there’s no monetary policy offset.
By that calculation, Mnuchin has already presided over enough dollar weakness to boost GDP by 1% through the end of Donald Trump’s first term—an amount that far exceeds the impact of the tax overhaul, Ruskin said.
On the other hand, a weak dollar could hurt U.S. equities if the inflationary impact of the decline undermines the bond market, pushing up Treasury yields. Yields and debt prices move in opposite directions.
“Here the Fed trade model suggests it needs a large 10% [trade-weighted index] decline to add 0.25% – 0.5% to the core [personal consumption and expenditures] deflator over a year. While USD weakness has accelerated, it is less obvious that the bear market for bonds is about to immediately accelerate sharply with it, in no small part because inflation pass-through is so modest,” he said.
The bond bear-market scenario, however, could get an added push if trade tensions generate “official” selling of U.S. Treasurys by foreign holders, he said. Chinese officials earlier this month denied a Bloomberg report that Beijing was weighing whether to slow or halt purchases of Treasurys, in part due to rising trade tensions.
“The one country where retaliation matters in a way that would give U.S. equities second thoughts remains China. So far, China has greeted U.S. actions on trade with barely a blink, but generally has a policy approach of ‘proportionality’ or proportional retaliation,” Ruskin said, while reiterating that retaliation via Treasury sales wouldn’t be a logical proportional response not least because it would hurt China’s own interests.
In the end, if China doesn’t “up the ante on trade,” risky assets should trade OK, Ruskin said, and the dollar will weaken against most currencies. If China responds in a way that is “risk-negative,” it will hit emerging markets, leaving dollar weakness concentrated against its major rivals.