Harder, Better, Faster, Stronger? Is Talk Enough To Weaken The Greenback?

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Includes: DRR, ERO, EUFX, EUO, FXE, UDN, ULE, URR, USDU, UUP
by: Principal Financial Group

By Seema Shah, Global Investment Strategist, Principal Global Investors

Is it better to be weak or strong? Almost everyone in almost every situation would probably answer "strong." However, when it comes to the relative strength of a country's currency, the answer isn't as clear-cut. For the United States, most presidents have espoused a "strong" dollar policy, or avoided discussing the dollar's strength all together. Newly-minted president Donald Trump and his administration appear to be following a different path. That's probably not a surprise.

The Trump administration talks of being harder on terrorism, better at manufacturing, and faster to confirm Cabinet nominees. But, in what may be the only instance of his administration arguing that the United States should be weaker, Trump and his surrogates seem to have been trying to talk down the value of the dollar on several recent occasions. "Our companies can't compete with [China] now because our currency is too strong," the president says. "And it's killing us." Trump's top trade adviser, Peter Navarro, recently told the Financial Times that Germany is using a "grossly undervalued" euro to "exploit" its European Union partners and the United States.

As with most things in a globally-connected economy, the truth - as well as the investment implications - is more nuanced. That's another way of saying that Navarro is half-right about the effect, and totally incorrect on the motive. The euro is almost certainly undervalued with respect to Germany. If you think hypothetically about Germany leaving the European Union (NYSEARCA:EU), its currency would undoubtedly strengthen because it would be free of the sovereign debt crises that have plagued its southern EU neighbors.

The flip side of this situation is that a hypothetically Germany-free EU would see its currency weaken. So for several euro-area countries like Greece, Portugal, and Spain, the euro is contrastingly overvalued. So, Navarro is half right about the effect; Germany is essentially dealing with a relatively undervalued currency.

But, "exploiting"? No.

Central bank policy partially drives currency performance, and for the past two years, the policies of the Federal Reserve (Fed) in the United States and the European Central Bank (ECB) have been diverging. The ECB has a massive bond-buying program to keep rates low, while the Fed has curtailed asset purchases and moved policy rates higher. Moreover, the ECB is an independent central bank, and if they're doing it right, they won't be influenced by politics from any individual country.

That said, Germany has been critical of ECB policy, calling it too expansionary. So, if the ECB had been unduly influenced by Germany, it would have tightened monetary policy and the euro would have strengthened. So it strains credulity implying that Germany is intentionally working to keep the euro undervalued in order to disadvantage the United States.

The current consensus view is that a strong U.S. economy and a few rate hikes from the Fed will push the U.S. dollar higher, or at least prevent it from falling. If Trump's weak-dollar rhetoric becomes reality, expect to see a boost to U.S. exports. I would also expect the U.S. trade deficit to narrow and the U.S. economy to grow a bit faster. That stronger growth would benefit U.S. equities as well as U.S. credit, particularly non-investment grade, since the bias in high yield is a domestic one. More time, though, could show more inflationary pressures mounting from the weaker currency.

Around the world, where currencies would strengthen relatively, the effects would be opposite. Goods from Europe, China, and Japan would become less attractive to foreign buyers. As a result, global equity and credit markets could struggle in a weak-dollar world. Temper that negativity though; the global economy would benefit somewhat from stronger U.S. growth and emerging markets would see reduced capital outflows.

Trump has more than his weak-dollar rhetoric though. It's difficult to see a protracted weakening of the dollar with the protectionist trade talk that's marked the first few weeks of the Trump presidency. And with both the ECB and the Bank of Japan expanding monetary policy while the Fed is tightening, it may take more than the weight of his words for Trump to tip the scales in favor of a weaker dollar.

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