Our U.S. Public Policy and Currency analysts, Ariana
Salvatore and Andrew Watrous, discuss why the
dollar fell at the beginning of the first Trump administration
and whether it could happen again this year.
----- Transcript ----
Ariana Salvatore: Welcome to Thoughts on
the Market. I'm Ariana Salvatore, Morgan Stanley's U.S. Public
Policy Strategist.
Andrew Watrous: And I'm Andrew Watrous, G10
FX Strategist here at Morgan Stanley.
Ariana Salvatore: Today, we'll focus on the
U.S. dollar and how it might fare in global markets during the
first year of the new Trump administration.
It's Tuesday, March 4th at 10am in New York.
So, Andrew, a few weeks ago, James Lord came on to talk about the
foreign exchange volatility. Since then, tariffs and trade policy
have been in the news. Last night at midnight, 25 percent tariffs
on Mexico and Canada went into effect, in addition to 10 percent
on China. So, let's set the scene for today's conversation. Is
the dollar still dominant in global currency markets?
Andrew Watrous: Yes, it is. The U.S. dollar
is used in about $7 trillion worth of daily FX transactions. And
the dollar's share of all currency transactions has been pretty
stable over the last few decades. And something like 80 percent
of all trade finance is invoiced in dollars, and that share has
been pretty stable too.
A big part of that dollar dominance is because of the depth and
safety of the Treasury security market.
Ariana Salvatore: That makes sense. And the
dollar fell in 2017, the first year of the Trump administration.
Why did that happen?
Andrew Watrous: Yeah, so 2017 gets a lot of
client attention because the Fed was hiking, there was a lot of
uncertainty about would happen in NAFTA, and the U.S. passed a
fiscally expansionary budget bill that year.
So, people have asked us, ‘Why the U.S. dollar went down despite
all those factors?’ And I think there are three reasons. One is
that even though the possibility that the U.S. could leave NAFTA
was all over the headlines that year, U.S. tariffs didn't
actually go up. Another factor is that global growth turned out
to be really strong in 2017, and that was helped in part by
fiscal policy in China and Europe. And finally, there were some
political risks in Europe that didn't end up materializing.
So, investors took a sigh of relief about the possibility that I
think had been priced in a bit that the Eurozone might break up.
And then a lot of those factors went into reverse in 2018 and the
U.S. dollar went up.
Ariana Salvatore: So, applying that
framework with those factors to today, is it possible that we see
a repeat of 2017 in terms of the U.S. dollar decline?
Andrew Watrous: Yeah, I think it's likely
that the U.S. dollar continues to go lower for some of the same
reasons as we saw in 2017. So, I think that compared to 2017,
there's a lot more U.S. dollar positive risk premium around trade
policy. So, the bar is higher for the U.S. dollar to go up just
from trade headlines alone.
And just like in 2017, European policy developments could be a
tailwind to the euro. We've been highlighting the potential for
German fiscal expansion as European defense policy comes into
focus. And unlike in 2017, when the Fed was raising rates, now
the Fed is probably going to cut more this year. So that's a
headwind to the dollar that didn't exist back in 2017.
So, on trade, Ariana. What developments do you expect? Do you
think that Trump's new policies will make 2025 different in any
way from 2017?
Ariana Salvatore: So, taking a step back
and looking at this from a very high level, a few things are
different in spite of the fact that we're actually talking about
a lot of similar policies. Tariffs and tax policy were a big
focus in 2017 to 2019, and to be sure, this time around, they are
too, but in a slightly different way.
So, for example, on tax cuts, we're not talking about bringing
rates lower on the individual and corporate side. We're talking
about extending current policy. And on tariffs and trade policy,
this round I would characterize as much broader, right? So, Trump
has scoped in a broader range of trading partners into the
discussion like Mexico and Canada; and is talking about a
starting point that level-wise is much higher than what we saw in
the whole 2018 2019 trade friction period.
The highest rate back then we ever saw was 25 percent, and that
was on the final batch of Chinese goods, that list four. Whereas
this time, we're talking about 25 percent as a starting point for
Mexico and Canada.
I think sequencing is also a really important distinction. In
2017, we saw the tax cuts through the Tax Cuts and Jobs Act
(TCJA) come first, followed by trade tensions in 2018 to 2019.
This time around, it's really the inverse. Republicans just
passed their budget resolution in the House. That lays the
groundwork for the tax cut extensions.
But in the meantime, Trump has been talking about tariff
implementation since before he was even elected. And we've
already had a number of really key trade related catalysts in the
just six weeks or so that he's been in office.
Andrew Watrous: So, you mentioned
expectations for fiscal policy. What are recent developments
there, and what do you think will happen with U.S. fiscal?
Ariana Salvatore: I mentioned the budget
resolution in the house that was passed last week. And you can
really think of that as the starting point for the reconciliation
process to kick off. And consequently, the extension of the Tax
Cuts and Jobs Act.
To be clear, we think that House Republicans will be able to
align behind extending most of the expiring Tax Cuts and Jobs
Act, but that's still in the books until the end of 2025. So, we
see many months needed to kind of build this consensus among
cohorts of the Republican caucus in Congress, and we already know
there's some key sticking points in the discussion.
What happens with the SALT [State and Local Tax] cap? What sort
of clawbacks occur with the Inflation Reduction Act? All
these are disagreements that right now are going to need time to
work their way through Congress. So not a lot of alignment just
yet. We think it's going to take most of the year to get there.
But ultimately, we do see an extension of most of the TCJA, which
is like I said, current law until the end of 2025.
But Andrew from what I understand when it comes to fiscal policy,
there are really two stages in terms of the market impact that we
saw in the last administration. Can you walk us through those?
Andrew Watrous: Yeah, so one lesson from
2016 to 2018 is that there were really two stages of when fiscal
developments boosted the dollar. The first was right after the
U.S. election in 2016, and the second was much later after the
Tax Cuts and Jobs Act passed. So right after the 2016 election,
within a couple of weeks, the dollar index rallied from 98 up to
103, and 10-year Treasury yields rose as well.
And then things sort of moved sideways in between these two
stages. Ten-year Treasury yield just moved sideways. Fiscal
wasn't as supportive to the U.S. dollar. And as we know, the
dollar went down. And then we had the second stage more than a
year later. So, the TCJA was passed in December 2017. And then
the dollar rallied after that along with the rise in Treasury
yield.
So, we think that now, what we've seen is actually very similar
to what happened in 2017, where the dollar and yields moved a lot
after the 2024 election; but now the budget reconciliation
process probably won't be a tailwind to the dollar until after a
tax cuts extension passes Congress. And as you mentioned, that's
not going to be for many, many months. So, in the interim, we
think there's a lot of room for the dollar to go down.
Ariana Salvatore: And just to level set our
expectations there to your point, it is probably going to be
later this year. House Republicans have to align on a number of
key sticking points. So, we have passage somewhere on the third
or fourth quarter of 2025.
But when we think about the fiscal picture, aside from the
deficit and the macro impacts, a really key component is going to
be what these tax changes mean for the equity market. The
extension of certain tax policies will matter more for certain
sectors versus others. For example, we know that extending some
of the corporate provisions, aside from the lower rate, will have
an impact across domestically oriented industries like
industrials, healthcare, and telecom.
But Andrew, to bring it back to this discussion, I want to think
a little bit more about how we can loop in our expectations for
the equity market and map that to certain dollar outcomes. How do
you think that this as a barometer has changed, if at all, from
Trump's first term?
Andrew Watrous: Yeah, currency strategists
like me love talking about yield differentials. But from 2016 to
2018, the U.S. dollar did not trade in line with yield
differentials. Instead, in the initial years of President Trump's
first term, equities were a much better barometer than interest
rates for where the U.S. dollar would go.
After President Trump was elected in 2016, U.S. stocks really
outperformed stocks in the rest of the world, and the U.S. dollar
went up. Then in 2017, stocks outside the U.S. caught up to the
move in U.S. stocks, and the U.S. dollar fell. Then in 2018, all
that went into reverse, and U.S. stocks started outperforming
again, and the U.S. dollar went up.
So, what we've been seeing in stocks today really echoes 2017,
not 2018. Stocks outside the U.S. have caught up to the post
election rise in U.S. stocks. And so, just like it did in 2017,
we think that the U.S. dollar will decline to catch up to that
move in relative stock indices.
Ariana Salvatore: Finally, Andrew, we
already discussed the U.S. dollar negative drivers from 2017. But
what happened to these drivers the following year in 2018? And is
that any indication for what might happen in 2026?
Andrew Watrous: So 2018, as you mentioned,
does offer a blueprint for how the U.S. dollar could go up. So,
for example, if trade tensions evolve in a direction where our
economists would have to significantly downwardly revise their
global growth forecasts, then the U.S. dollar could start to look
more attractive as a safe haven. And in 2018, there was a big
rise in long-end Treasury yields. That's not what we're calling
for; but if that were to happen, then the U.S. dollar could catch
a bid.
Ariana Salvatore: Andrew, thanks for taking
the time to talk.
Andrew Watrous: Great speaking with you,
Ariana.
Ariana Salvatore: And thanks for listening.
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