Tianfeng: Can the strength of the US dollar be sustained?

The strong dollar remains the "Trump trade" before taking office on January 20th. After the election, the US dollar index showed a strong upward trend, triggering a series of chain reactions. Before the election, the dollar index was around 103, and after the election, the index began to rise, reaching a high of nearly 108 points at one point; after briefly falling back to 105 to 106 points, the hawkish stance of the Fed's December FOMC meeting pushed it back above 108. First, the short-term strength of the dollar is closely related to market expectations of Trump's economic policies after his return. The market widely believes that Trump's tax cuts and deregulation will stimulate economic growth in the United States, thereby boosting real growth. The change in the dollar index reflects the relative difference in real growth between the US and other countries, which is the first factor contributing to the strength of the dollar. Second, it involves inflation and interest rate policies. Before the election, US inflation had already rebounded consecutively. With Trump's return, the market expects the US to face higher levels of inflation. Trump's policies, including limiting immigration, raising tariffs, and tax cuts, may push inflation further up at both ends of supply and demand. If inflation continues to rise, the likelihood of the Fed cutting rates will decrease. Third, Trump's return also brings policy uncertainty. Judging from the speed of Trump's cabinet formation, it is five times that of the Obama and Biden era, and six times that of the Bush era. After taking office, it is possible that policies will be accelerated, shortening the market's forecasting window. The increase in uncertainty also prompts a short-term strengthening of the dollar index. This scene is similar to the rebound of the dollar index after Trump's election victory in 2016, which rose by 6.4% from a low point. At that time, the US economy gradually transitioned from destocking to restocking, and the currency was also in a rate-hiking cycle. Trump's unexpected election victory increased market uncertainty, further pushing the dollar up. However, the strong dollar only held on until the end of 2016 and then began to weaken. In 2017, the US dollar index trended lower overall, while in 2018, the dollar fluctuated but strengthened due to trade tensions between the US and China, ultimately depreciating by 10.2% during Trump's first term. Trump's "impossible triangle" will weaken the dollar. If economic efficiency does not improve, there may be conflicts between Trump's goals, either inflation, deficits, or the economy, one of them must give in. The contradictions between Trump's policies mean that they cannot all be implemented simultaneously. For example, if production efficiency cannot be improved or government spending reduced, tariffs and tax cuts may lead to rising inflation. Suppressing inflation through rate hikes will put pressure on the economy, contradicting the low-interest rate tendency. Trump's policy of putting the dollar first requires expanding the share of the dollar as an international reserve currency, which contradicts isolationism and efforts to reduce trade deficits. Furthermore, cutting the deficit could lead to a decline in demand, releasing a large amount of labor on the one hand and cutting government spending on the other. If the drop in demand cannot be offset by the stimulative effects of tax cuts and deregulation, signs of recession could appear first, contradicting the goal of avoiding economic recession and stock market decline, with Trump seeing the stock market as one of his key KPIs during his term. To avoid economic recessions and stock market declines, fiscal expansion needs to be maintained, conflicting with the goal of cutting the deficit. Therefore, when Trump returns with his team on January 20th, many policies may not be as expected by the market, leading to a gap between strong expectations and weak realities. If policies cannot be implemented or have effects vastly different from expectations, then expectations of inflation and economic growth may not align with the current strong pricing direction of the dollar. Additionally, the dollar index is also relative and depends not only on the performance of the US economy but also on the economic conditions of non-US economies after Trump's return. Since the outbreak of the Russia-Ukraine conflict, the European economy has been under continuous pressure from energy supply instability, price increases, and ongoing geopolitical risks. The originally weaker "PIIGS" countries in Europe, due to their lack of manufacturing and smaller reliance on Russian energy, have relatively better economic performance, while strong Western European countries like Germany and France are facing economic difficulties, with Germany's manufacturing PMI declining for two consecutive years and France's economic situation even being compared to Greece. Regarding the performance of the European economy, Trump's return and the change in US foreign policy may be a turning point. The ceasefire proposed by Trump between Russia and Ukraine is to some extent reasonable and realistic. If the conflict can be temporarily halted, the pressure on European energy supply and prices will also ease, which will help improve the long-term capital expenditure levels and investment outlook for European manufacturing. If the European economic locomotive Germany can recover from its current predicament, it will attract funds flowing out of the US, further weakening the strength of the dollar. 25 years of American V-shaped inflation, first down and then up. Recently, Musk shared an anecdote through Twitter, where a friend of his found that staff at the SEC were unfamiliar with how to turn on lights due to working from home for a long time, eventually using the flashlight on their phones to conduct a meeting in a dimly lit room. This experience led Musk to criticize the inefficiency and waste of taxpayer money in government departments. The first to be cut will be those government department spending that is inefficient and ideologically driven, which is a form of fiscal contraction that leads to government employees becoming unemployed, reduced income, and decreased demand, becoming the primary factor in suppressing inflation. In addressing the issue of illegal immigration, the Trump administration may take stricter measures, including possibly deploying the military and building more detention centers for deporting immigrants; this is a very difficult process, and expelling illegal immigrants is not easy, but there are variables in limiting new immigrants, such as the incoming Senate Majority Leader Thurmond's insistence on passing the first bill within 30 days of Trump taking office, with a focus on ensuring spending related to border security; this may have a headwind effect on potential future job growth. Suppressing oil prices is another way Trump's administration can reduce inflation. During his campaign, especially during visits to oil-producing states, Trump often used the slogan "drill baby drill", and his newly appointed Secretary of Energy is an oil tycoon who opposes climate change. By relaxing regulations on oil and gas drilling, oil prices can be adjusted and inflation can be suppressed, helping in reducing inflation. In conclusion, these factors together, including policy contradictions, economic conditions, and uncertainties, suggest that the strength of the US dollar will face challenges in the coming period.It is relatively easy to achieve inflation control. In addition, if the conflict between Russia and Ukraine is eased, Russian oil may re-enter the international market, reducing friction costs and possibly causing oil prices to fall. The stability of the Red Sea route and the reduction of geopolitical risks, especially the decrease in risks along the Asia-Europe shipping route, will also exert downward pressure on oil prices.Finally, considering the base effect of the high inflation before and low after in the United States, the tail factor will cause inflation to first decrease and then rise. Due to the pain brought by Musk's DOGE reform, government layoffs and spending cuts may put pressure on the economy, giving Powell more reason to continue cutting interest rates in the first half of next year. Although Powell claims "no speculation, no inference, no assumption," avoiding economic recession and a big stock market drop is also the responsibility of the Fed. (IV) Re-inflation and re-interest rates in the second half of the year It is unlikely that the Plus tariffs will be smoothly implemented, which may damage relations with allies and involve the interests of the Democratic and Republican establishment. The more likely scenario is that the president will declare a national emergency status (IEEPA) through executive order, then use the 301 clause for investigation, imposing targeted tariff increases on countries and goods with large trade deficits. This is consistent with the views of the Treasury Secretary nominee Benson nominated by Trump, who opposes universal tariff increases, advocates hierarchical and targeted tariffs, and sees tariffs as a means rather than an end. Therefore, the actual tariff policy may start with threats, and if the threats are ineffective, both sides may escalate, announce the imposition and finally implement the tariffs, which will further delay the time when inflation is affected by tariffs. If the tariff policy is eventually implemented, it may have an impact on inflation in the second half of the year, rather than immediately. Trump's tariff policy mainly affects the tradable sector's inflation. However, the current inflation problem in the United States is mainly concentrated in the non-tradable sector (core services). Inflation stickiness has been present in the United States, with core inflation rising above 0.28% month-over-month in the past four months, especially since Powell's dovish turn began in August, inflation has shown extreme stickiness, with the US CPI and core CPI in November both rising 0.3% month-over-month. The three-month annualized and year-over-year growth of core CPI has rebounded to above 3%, and core CPI year-over-year may further rise to the 3.5% to 4% level. Overall CPI has been at a steady 0.2% for the past five months, while core CPI has been close to 0.3% for four consecutive months. The rebound in inflation is not only reflected in the overall data, but also in specific sub-items which better reflect the U.S.'s internal dynamism, with service inflation particularly strong. Despite the relatively high interest rates, due to limited housing supply and the income and wealth growth of affluent populations, house prices have not been greatly suppressed and have remained at high levels, directly affecting housing inflation including rent and equivalent rent for owners. In addition to housing inflation, the level of service consumption inflation is closely related to wage growth. The labor market supply and demand tend to balance each other out, and demand remains strong, while long-term supply is on a downward trend. Since the outbreak of the epidemic, the decrease in supply has been mainly due to an increase in the number of retirees and many people unwilling to work due to excessive subsidies. The decrease in immigration numbers in the early stages of the epidemic has also limited labor supply, so the labor participation rate in the US has not significantly increased compared to before the pandemic. In a situation where supply and demand are relatively balanced and demand is strong, nominal wage growth remains sticky, which in turn supports core service inflation. Trump will continue to restrict immigration, which will put pressure on inflation in the non-tradable sector, especially on wages in the low-skilled service industry, further exacerbating the inflation problems in the United States. The Fed may continue to cut interest rates in the first half of the year due to a decrease in inflation, but Trump's regulatory relaxation and imposition of tariffs will bring additional inflation pressures, coupled with low base effects, U.S. inflation may undergo a trend change of decline followed by rise. If core inflation levels accelerate to 3.5-4% in the second half of the year, the Fed may be forced to raise interest rates again by the end of the year. For China, the Fed's rate cuts in the first half of the year corresponded to the revaluation of the renminbi, with monetary easing, interest rate cuts, and fiscal debt issuance. If the Fed is unable to cut interest rates or even begins to consider raising them, pressure on the renminbi exchange rate will appear, and the policy window will also be affected. This article is reproduced from the WeChat public account "Xue Tao Macro Notes"; authors: Song Xuetao, Wang Anni; GMTEight editor: Xu Wenqiang.