The president, the stimulus, and the dollar

In the lead up to every election, there are inevitable questions from investors of what each candidate’s policies will mean for the economy, the stock market, and the U.S. dollar.

Though American presidents have limited direct control over the direction of the USD, their words and policy actions have significant influence. The USD declined by 12% during Trump’s first year in office. Treasury Secretary Steven Mnuchin’s championing of a weaker U.S. currency also contributed to some of the decline. However, it would be inaccurate to suggest that Donald Trump being president caused the dollar to weaken. In fact, it had strengthened significantly upon his election and recovered almost all the losses prior to the coronavirus pandemic last year.

Upon Biden’s election, and subsequent victory in the Senate that gave the Democrats control of both houses of Congress, many currency forecasters were predicting that the dollar would weaken by as much as 10% this year. So far in 2021, the dollar index has strengthened by 2%. Comparing movements in long-term interest rates can help explain some of the differences in the dollar’s fortunes.

Since the start of the year, there has been a large move up in long-term interest rates. The benchmark 10-year U.S. Treasury yield has risen by ~60 basis points (bps) to 1.70%. This compares with a rise of just 8 bps in the same period of 2017. Looking at a specific currency’s 10-year yield spread in the table below, we can get some idea of the impact of yield on its value vs the U.S. dollar.

Sentiment is another key contributor to whether the U.S. dollar, as the world’s de facto reserve currency, strengthens or weakens. Periods of relatively stable global growth and favourable fiscal policies, such as Trump’s vast proposed tax cuts in 2017, allow for heightened risk tolerance, pushing money into riskier, higher yielding assets typically outside of the U.S. which can cause the dollar to weaken. But in periods of elevated global fear, or market stress such as in March 2020, risk aversion takes hold, pushing assets into relative “safe havens” like U.S. Treasuries and the U.S. dollar, causing it to strengthen and even leading to temporary market distortion.

One might expect deteriorating sentiment, and thus a weakening dollar, due to the concern that the $1.9 trillion stimulus package will overstimulate the U.S. economy and drive inflation higher, causing the Federal Reserve to tighten monetary policy much earlier than it is communicating. However, the risk of earlier policy normalisation by the Federal Reserve appears to be having a greater influence on investor behaviour evidenced by a strengthening dollar as of late.

Some Fed officials have mentioned tapering the central bank's asset purchases. But Chairman Jerome Powell quickly rebuffed concerns of premature tightening and has repeated such reassurances on several occasions. The mixed communication has raised concerns and prompted some of the largest one-day moves in U.S. Treasury yields in recent weeks.

The relative attractiveness of U.S. financial assets is starting to increase again, following the Fed’s significant monetary policy action just over a year ago. Interest rate differentials, especially currencies whose economies are beset with disinflationary problems (such as the Eurozone and Japan) are widening.

No matter who is president, they all face the same dichotomy; on the one hand, a stronger dollar is a signal of market confidence in the United States and that’s attractive, while on the other, a stronger dollar also acts as a headwind for trade.

In summary, there are many different influences on currency movement. This year has had a particularly volatile start with sentiment around vaccine success and the lifting of lockdown restrictions impacting short-term movements. Making sure you have the appropriate understanding of FX risks faced and the strategies to mitigate them will be critical to ensuring the key financial metrics are exceeded or achieved.

^{* Since no commonly issued bond exists for the eurozone, German Bunds are considered the benchmark for the euro area and are used in this comparison.}