C+ For Trump's Report Card, And Peak Dollar

Includes: FXA, TLT, UUP
by: Max Loh

Republicans suffered a very poor showing in the US mid-terms elections, which would most likely lead to political gridlock going forward.

The immediate market reaction was for the USD to sell off, with the markets starting to price in a softer inflation outlook due to Trump's expansionary policies potentially being crippled.

Buy the AUD against the USD, with Trump likely to adopt a softer diplomatic stance towards China to win back voters, as well as a softer inflation outlook going forward.

The Trump-reversal trade is on.

The US mid-term elections were a chance for the people of the United States to express their satisfaction or dissatisfaction towards their president, and they promptly did, by grading Trump a plump "C+".

The Republicans managed to extend their control over the Senate, but that was largely expected given that almost half of the seats previously held by the Democrats were up for contest. The dynamics of the Senate battleground were uneven, not so for the House of Representatives though, with the Democrats scoring a whopping 219 to 195 victory out of the 414 seats contested. This was a huge turnaround in margins, given that the Republicans won 240 seats in the 2016 elections.

What this means for Trump is that his domestic policies are going to face huge resistance and gridlock in Congress. His promised 10% tax cut for the middle-income bracket will most probably fail to bear fruit, along with Trump's plans to repeal Obamacare. The rationale to repeal Obamacare was simple - the Republicans want to alter the budget to make space for Trump's fiscal policies (e.g. tax cuts, infrastructure spending, building a Mexican wall). Congressional gridlock will probably halt Trump's populist measures going forward.

The market's reaction to the mid-term election results was to sell the Greenback. The expected lack of push-through for Republican plans to stimulate the economy and expand spending would likely lead to tamer inflationary pressures, which then decreases the need for the Federal Reserve to raise rates aggressively.

The Dollar Index (UUP) has fallen close to 0.7% at the time of writing, and the double rejection near 97 levels looks likely to be a double top for the Greenback. This is bearish, and I expect the Dollar to test 94 levels (lower bound of the range it has been trading in this year). The Dollar's slide today has also been in line with the fall in US Treasury yields (TLT), with the 10-year yield retreating close to 7bps from 3.25% to 3.176% currently. Clearly, the market is starting to price in milder inflation in the economy due to the change in the political landscape.

The focus of the market will now be on Trump's diplomatic stance going forward. The Republicans' poor showing in the mid-terms are a manifestation of the people's disgruntlement towards Trump's brash treatment of the country's trade partners. Mexico and Canada were made to sweat over NAFTA, and the US is now engaged with China in tit-for-tat trade tariffs. Trump and Xi Jinping meet at a G20 summit at the end of the month, and the pressure is now on Trump to win back the goodwill of the voters with a deal that benefits Americans. More tariffs or a no-deal scenario would likely distance the Republicans further away from the people.

Once again, this scenario is dollar-negative. Tariffs on Chinese imports serve to push up prices via imported inflation. Goods become more expensive, placing pressure on the Federal Reserve to hike interest rates more aggressively. Should Trump adopt a less confrontational diplomatic stance, the Greenback is expected to weaken on a milder inflationary outlook.

In conclusion, I would suggest to investors to divest out of the USD as we might be seeing a "peak-dollar" situation. Add to the fact that Treasury shorts are at historical highs, according to famed investor Jeff Gundlach. This means the market is heavily positioned for interest rates to rise higher. Should the markets start to price in a softer inflation outlook post-mid-terms, this overcrowded trade could see a massive short squeeze, which will no doubt send the Dollar lower.

One likely beneficiary would be the AUD (FXA), which is a liquid proxy for China's economic well-being. The AUD once enjoyed the status of a carry currency, until US interest rates overtook Australia's. As such, the AUD has seen massive selling pressure due to the US-China trade war as well as the USD providing a higher carry. A reversal in Trump's brand of politics could mend the relationship between US and China, as well as convince the Federal Reserve to adopt a more conservative hiking stance.

These two factors would likely send AUD/USD higher. The AUD/USD is trading 10% below its 52-week high of 0.8130, and I suggest buying the currency at current levels (0.73), with a take profit at 0.78 and a stop loss just below the key psychological level of 0.70.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.