Investors are betting that Donald Trump will boost the dollar

The trade is based on the idea that a second Trump administration would be positive for American stocks, bad-but-not-terrible for Treasuries and great for the dollar. Equity returns would be boosted by corporate-tax cuts and deregulation. These very same tax cuts would increase government borrowing, lowering bond prices and lifting yields—but not by enough to destabilise the economy and hit stockmarket returns. All of this would lift the dollar, which has generally moved in line with the interest rate available on American ten-year bonds in recent years (see chart).

It might seem strange that the prospect of fiscal deterioration and faster price rises would be positive for America’s currency. In general, currencies lose value when public finances worsen and inflation climbs. But the dollar plays a unique role in the global financial system as the ultimate source of liquid safe assets. Higher yields on Treasuries, even when the product of fiscal profligacy, tend to make holding dollars more attractive.

Those who have bought into the Trump trade expect such a dynamic to continue. They also believe that Mr Trump’s threat to increase tariffs would add to the dollar’s lustre: blockages on imports would lead to fewer dollars leaving America, pushing their price higher. They might be right. But there are at least four ways in which Mr Trump could, in fact, weaken the dollar. Together, they suggest caution on the Trump trade.

The first concerns monetary policy. Mr Trump may take a more forceful line on the Federal Reserve than during his first term, by browbeating the institution into holding interest rates lower or even interfering with its independence. There are plenty of reasons to think the Fed could resist Mr Trump. But if he was successful, lower interest rates than warranted by inflation would produce a weaker dollar.

Mr Trump would not be upset by this outcome. America, he told Bloomberg, a news service, “has a big currency problem”. In his mind, the strength of the dollar, which Mr Trump blames in part on currency manipulation by trading partners, has hurt American manufacturers by making their goods less competitive internationally, and thus cost jobs. Robert Lighthizer, a trade adviser to Mr Trump, is another long-term critic of a strong dollar.

Of course, desiring a weaker dollar is one thing; achieving a weaker dollar is quite another. Most traders expect Mr Trump would moan that the dollar was too strong even as his own policies pushed the currency higher. There is, however, a chance that his tariffs would represent an opening salvo in negotiations designed to enlist trading partners into a collective effort to bring down the dollar, as happened under Ronald Reagan in the 1980s—a second reason for caution on the Trump trade.

The next reason concerns tariffs. Historically, they have tended to raise an exchange rate in the short term—but then to lower it over the longer term. The initial impact of more trade friction is often lower imports and exports, as well a weaker domestic economy. A weaker economy then leads to lower interest rates, diminishing the appeal of a currency and pulling it lower.

The final risk comes not from Mr Trump’s economic agenda, but from his foreign-policy instincts. Barry Eichengreen of the University of California, Berkeley, has studied the geopolitical underpinnings of international currencies. In an article published in 2019 he noted that countries enjoying an American security guarantee hold more of their reserves in the currency of the guaranteeing power. Japan, for example, holds more of its reserves in dollars than China. Even Germany holds a higher proportion of its reserves in dollars than France, which possesses its own nuclear deterrent. In the event of America dropping its security promises to allies, as Mr Trump has occasionally threatened, Mr Eichengreen and his co-authors believe that American interest rates could rise by 0.8 percentage points and the dollar decline.

Ultimately, the logic behind the Trump trade, when it comes to the dollar, is that Mr Trump would be fiscally reckless but otherwise restrained. Investors imagine that he would increase borrowing in a way which makes the dollar more attractive to investors without undermining the institutional framework that underpins the currency’s global role. It is a brave bet to make.

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