Analysis: Trump's victory emboldens dollar bulls preparing for tariffs

By Saqib Iqbal Ahmed

NEW YORK (Reuters) – Donald Trump's impending return to the White House is putting the U.S. dollar in the spotlight, which could have far-reaching implications for everything from domestic manufacturers to emerging markets if the currency's rally continues.

The U.S. currency posted its biggest daily gain against its peers in eight years on Wednesday, a day after Trump was re-elected president and Republicans gained control of the Senate while making gains in the House of Representatives. The dollar is up 3.8% this year and is at its highest level in four months.

How far the dollar continues to rise could depend on whether investors believe Trump will push through the tax cuts and tariffs that are key elements of his economic platform. While these measures could boost growth, they risk stoking inflation and could keep U.S. interest rates well above those of other countries. Higher interest rates make the dollar more attractive to investors.

At the same time, a strong dollar could hurt U.S. businesses — one reason the president-elect regularly railed against a rising dollar during his first term.

“A Trump administration likely means more spending, a hotter economy and high standards for international trade — all things that mean strength for the dollar,” said Helen Given, deputy trade director at Monex USA.

PRICE HISTORY

The evolution of interest rates is crucial to the dollar's future prospects. The Federal Reserve began its latest monetary easing cycle with a 50 basis point rate cut in September and is expected to announce a 25 basis point cut at the conclusion of this week's two-day policy meeting on Thursday.

Expectations of interest rate cuts contributed to the weakening of the dollar earlier this year.

But the prospect of higher inflation could make policymakers wary of overheating the economy by cutting interest rates too much. Traders on Wednesday reduced their bets on how much the Fed would cut interest rates next year, from 62 basis points last month to about 42 basis points, based on LSEG calculations.

“I would describe this as a tectonic shift in the foreign exchange markets,” said Paresh Upadhyaya, director of fixed income and currency strategy at Amundi US. Investors must now consider “trade tariffs and the impact they will have on the U.S. inflation outlook, on the global growth outlook and … how the Fed will respond.”

A so-called red sweep scenario, in which Republicans control the White House and both chambers of Congress, could make it easier for Trump to push through tax cuts and give Republicans more room to pursue their economic agenda.

While Republicans were expected to have a majority of at least 52-48 in the U.S. Senate, final control of the lower chamber was still unclear as vote counting was still underway.

Brad Bechtel, global head of FX at Jefferies, believes the dollar could gain another 5% in a red sweep scenario and rise further in the coming months as more of Trump's agenda is implemented.

Trump will be sworn in on January 20th.

In 2016, the dollar rose about 6% against a basket of currencies in the first two months after Trump's election victory, but gave up those gains in the following months. The dollar rose about 13% between February 2018 and February 2020 as Trump imposed tariffs on several countries, including China and Mexico.

WAVE EFFECTS

A rising dollar could be a double-edged sword for the U.S. economy, helping to curb inflation while hurting the competitiveness of American products abroad. It could also put pressure on the profits of U.S. multinational companies that need to convert their foreign profits into dollars.

A JPMorgan study found that every 2% increase in the trade-weighted dollar reduces S&P 500 earnings growth by 1%, according to JPMorgan strategists.

If a rising dollar becomes a headwind for growth, Trump could exhort the Fed to cut interest rates or pressure U.S. trading partners to boost their own currencies.

Trump could also use the Exchange Stabilization Fund, which was created in the 1930s as a tool to stabilize the exchange rate and now has about $215 billion. Trump did not use the fund in his first term, and analysts are skeptical that such a move would effectively rein in the dollar without global efforts or support from the Fed.

“Trump's preference for a weaker dollar would have to be taken into account by and in coordination with the Federal Reserve, which we think is unlikely,” Wells Fargo analysts wrote in a report Wednesday.

Given the dollar's role as the linchpin of the global financial system, the U.S. currency's continued strength could impact other assets.

A strong dollar could be particularly unwelcome for emerging markets, especially countries that have borrowed heavily in the U.S. currency, as a rising dollar would make it harder for them to repay their debts.

That could put pressure on the central banks of these countries – as well as some developed countries such as Japan – to raise interest rates to defend their own currencies, Jefferies' Bechtel said.

“They will enter this new regime of currency war that has flared up again and again in the past,” he said.

Some investors believe tariffs could ultimately hurt the U.S. economy because they can increase costs for businesses and consumers, disrupt supply chains and reduce trade volumes. All of this could reduce the prospects for future dollar strength.

According to a study by Deutsche Bank, the tariffs, if introduced, would reduce US gross domestic product by about a quarter point.

“The reality is that a broad protectionist agenda will ultimately hit the American economy and slow growth,” said Karl Schamotta, chief market strategist at payments company Corpay.

(Reporting by Saqib Iqbal Ahmed; Editing by Ira Iosebashvili and Leslie Adler)

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