PM Perspectives: U.S. Dollar Outlook Dims In 2019 On Deficit Spending, Slowing Growth

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by: Janus Henderson Investors

By Christopher Diaz

While interest rate differentials will help the U.S. dollar maintain its value in the near term, there is potential for the currency to decline on expectations that growth may have peaked and as monetary stimulus is replaced by more government spending on the back of tax cuts that look likely, in combination, to lead to higher budget deficits.

Key Takeaways

  • Interest rate hikes by the Federal Reserve are likely to continue to provide near-term support for the U.S. dollar.
  • Longer term, the U.S. is heading for exceptionally large budget deficits, higher current account deficits and significantly higher debt-to-GDP levels.
  • Once the "sugar-high" of tax cuts and fiscal expansion wears off, the U.S. will be likely left with a markedly worse fiscal situation, placing pressure on both the dollar and potentially the country's credit rating.
  • Transcript

    Chris Diaz: The thesis short term has been that the dollar has been strong. We expect it to likely remain strong over the near term for a number of reasons, one of which is expectation for global growth was really that all countries, all regions, growth expectations were picking up. That has materialized in the United States, but it largely has not materialized around the rest of the world.

    When we look at the difference in central bank actions, the message generally has been a continuation of gradual tightening and raising of interest rates. The message around the world has been a little bit different, particularly in a place like Europe, where there have been concerns in the largest emerging market country in Europe, Turkey, the potential transmission mechanisms there to other European countries and its impact potentially on growth and inflation.

    So that has been certainly another reason why investors have preferred, frankly, to move away from euro-based assets into U.S.-based assets.

    And then, finally, there has been really a lot of rhetoric that has put additional pressure on emerging market currencies from the United States administration and from President Trump, whether that be talk of trade wars, additional tariffs, tariffs that have already gone into effect against a number of countries, most importantly China, the world's second-largest economy, and there are lists prepared to impose tariffs on further goods from China. This has put a lot of downward pressure on a lot of emerging markets.

    There has been talk for many years that the Bank of Japan was going to potentially exit this very easy, very accommodative monetary policy, but the reality is, they just can't come close to hitting their inflation target. Inflation today is hovering just north of zero. So, it seems unlikely that the central bank there will be raising rates. With the U.S. removing liquidity, the Bank of Japan adding liquidity, then it seems likely that the U.S. dollar could move higher here relative to the yen.

    We think that U.S. strength will ultimately fade, and we would view this short-term burst in growth as a sugar high, of sorts, in that it has been to a large degree a function of a tax cut, a very large tax cut. It has been a function of significant increase in fiscal spending. And these effects will fade, and ultimately, when they fade, they will leave behind a significantly worse fiscal situation than we started.

    The last time we had budget deficits this large was post-financial crisis, and that is usually when the U.S. government will go into fiscal deficit to act as a buffer for an economy that is in recession. Well, this is post-cyclical borrowing, in that we didn't really need it at this point, so it is going to lead to exceptionally large budget deficits. We are going to add significantly to the level of debt.

    So, increasing budget deficits, increasing current account deficits, significant increase in debt-to-GDP levels, this at the same time when growth is likely slowing, we're seeing the impact, the lagged effects of increases in interest rates from the Federal Reserve, and we will likely have more interest rate increases at that point, will likely create an environment where the United States looks like the most attractive country to invest in today, and we have grave concerns that that will not be the case at some point next year, maybe early, maybe mid- to second half of 2019.

    I would think that the dollar goes weaker. What had been in the favor of the U.S. - relative growth rate, inflation, productivity differentials - will decline and the fiscal situation will deteriorate materially. I think that it is not out of the realm of possibility that at some point the discussion begins to re-emerge regarding the credit quality of the United States and whether a potential downgrade is something that is going to be considered by the rating agencies. I think we recall the last time the U.S. had a credit downgrade. It was a pretty material shock to markets, in particular risk markets that performed very poorly upon hearing that news.

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    C-0918-19933 12-30-20

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