After the rampant appreciation seen over most of 2018, the US Dollar (USD) appears to be stuttering driven by a reversal of a number of supportive factors. While markets are questioning whether the US economy will be able to sustain its relative outperformance over the medium-term, concerns about global growth prospects have also intensified as data releases from China and the Euro-zone have disappointed expectations. The combination of these two conflicting factors has worked to limit the downside potential in the USD given that it witnesses some demand via the ‘safe-haven’ trade.
Some emerging uncertainties have started weighing on investors perception about the long-term growth outlook of the US economy. First, interest rate sensitive sectors such as housing and auto sales have started to weaken, showing that the economy is feeling the pinch of tightening domestic monetary policy over the last two years. Second, US credit spreads have started to widen raising concerns about the health of the private corporate sector given that the sector’s leverage has increased considerably. Financial conditions have also tightened visibly in certain segments such as the widening in US corporate spreads and an appreciating currency that could weigh on the economy with a lag. Lastly, the tailwinds of the fiscal stimulus that buffeted US growth in 2018 is also expected to fade in 2019. We need to emphasize that we are not expecting the US economy to fall into a recession. Instead, we see some normalization in the pace of growth from ~3% in 2018 to ~2.2% in 2019. A still fairly robust labour market should act as a buffer providing continued support to consumption via steady income increases. Nevertheless, the FX implications of a weakening US growth trend cannot be ignored either.
The most noticeable change can be traced to US monetary policy. The Federal Reserve has very aggressively started to send dovish messages and in its latest policy meeting emphasized that it is moving from a tightening stance in 2018 to a prolonged pause in 2019. Hence, the USD has lost twin supports and that has been reflected in FX movements since Decemeber-2018.
Will this unabashed bearish trend persist into 2019? The pace of growth in the US economy is expected to slow but the USD will only decline on a sustained basis if global growth holds up, that will mean reduced relative advantage of the US economy. So far, evidence of a softer growth profile in the non-US world has worked to limit the downside in the USD ensuring that the decline is not secular and a one-way street.
The upshot is that the US administration’s ‘protectionist’ drive will likely emerge as the main trigger for investors. The deadline (1-March-2019) of the temporary US- China trade-war cease fire that was agreed by the US and China is slowly coming to a close. Media reports indicate that China could be considering making some compromises by agreeing to ramp up purchases of US goods that would reduce the trade imbalance between the two regions but nothing has been officially confirmed. The other risk that still remains on the table is the prospect of the US President putting pressure on Europe with the possibility of increasing tariffs on European auto imports into the US. The US Commerce Department is due to release a report examining the threats to national security from auto imports sometime in February-2019 that will help the US President to make a decision.
Our base-case remains that some sort of compromise or agreement is likely, since neither China nor the Euro-zone can afford to be embroiled in a trade-war considering the fragile state of the respective economies. We suspect that slowing US growth momentum could in turn force the US administration to move towards getting a deal in place, as ‘tariffs’ could be inflationary in the medium-term and could work as a headwind hurting household real income levels. Hence, once there are visible signs of an improvement in the trade battle that provides some stability to the growth outlook of the non-US world, the USD will likely resume its decline.
(The article has been contributed by Treasury Research Group, ICICI Bank)