Many things affect the value of the US dollar. For most of 2017, three things have caused the dollar to move down at first and then up again. What will the future bring for the US dollar?
The dollar declined for the first part of the year. This was confusing. Most economists thought the dollar would continue climbing, just as it had been doing since President Trump’s victory. After all, tax reform and tighter monetary policy dominated the discussion. And these would lead to a higher dollar. But that didn’t happen.
Instead, the dollar declined as Washington’s policies stalled, though the Fed still tightened policy. Then something happened. The decline came to a sudden halt in early September. And then the dollar began to creep upward.
There have been three major movers of the dollar in 2017: the waxing and waning likelihood of the Trump Administration’s tax cuts, one-off issues in Europe, and the interaction of the policy decisions of the Federal Reserve and European Central Bank (ECB). All three remain important potential drivers of the dollar for the rest of the year and well into 2018.
The September catalyst is not difficult to pinpoint: resurgent tax reform rhetoric. As the tax reform rhetoric filtered through US financial markets, the result was higher US interest rates. And higher US interest rates typically mean a stronger US dollar.
Tax reform has the potential to spark some inflation pressures that could cause the Fed to raise interest rates at a faster clip than the market currently expects on the short end. On the long end of the curve, the inflation or the perception of future inflation from tax reform drives yields higher to compensate for the erosion of buying power. But there has been more to the story than what is at first obvious. For example, Europe has had its own set of issues lately. This is supposedly responsible for pushing the dollar lower.
The independence vote in Catalonia, Spain, has been cited as a driver of weakness in the euro. This could be a headwind for the dollar but probably only on a headline basis. Sure, Catalonia seems—intermittently—to want independence, but that does not appear to be working out well for the region as businesses leave or threaten to do so. After all, independence would exclude the region from the European Union and the ECB.
These secessionist headlines are unlikely to wane anytime soon. Instead, depending on how successful some movements are, others could flare up as well. There is no shortage of movements for secession or autonomy within Europe. If these headlines are going to weigh on the euro, they will do so for quite some time.
Why bother spending so much time concentrating on the euro? The euro constitutes roughly 60% of the most popular dollar index. This makes happenings in Europe of utmost importance to the value of the dollar.
The voters in Catalonia are not the only reason Europe matters. The ECB’s most recent monetary policy decision set a dovish, easier policy tone—not simply for the short term or until the next meeting, but until next September.
The ECB avoided a hawkish decision, such as only a small extension of quantitative easing (QE) at a lower monthly purchase amount. That would have pushed the dollar lower and the euro higher. Instead, the ECB issued a dovish policy decision. This further strengthened the dollar. It might also put some momentum behind the strong dollar trend.
It makes sense for the ECB to have a dovish plan to begin slowing Europe’s QE. It would lead to a lower euro and a fall in yields. The euro is already falling to levels seen in early October and even back throughout most of August. This is not an overly dramatic move, but it is a drop.
And this is partly due to the ECB spending months preparing the market for the announcement of its plan to eventually stop quantitative easing. This caused the euro to strengthen. In other words, Europe’s taper tantrum happened slowly over the past several months.
The pattern does not differ from when then-Fed Chair Bernanke began to guide toward the end of the Fed’s QE program. Except that the ECB did a better job. The ECB learned from the Fed’s mistakes.
The message from the ECB leading up to the taper announcement has been consistent. And it has said it would reinvest its bond holdings for the foreseeable future. This will keep rates low. The Fed has already begun to taper its reinvestments, but only just. So, the runway for a cautious ECB is long.
The ECB’s decision to remain dovish will affect the Fed’s own decision-making process and the value of the dollar going forward. The Fed is set to raise rates in December. This, along with the ECB’s dovishness, will cause the dollar to strengthen.
Now that the ECB’s policy stance is known, the immediate catalyst for change in the value of the dollar will be the success or failure of tax reform. Why? Because tax reform will largely determine the extent of the difference between the Fed’s and ECB’s policy stances.
So, the dollar will be subject to numerous crosscurrents. It is reasonable to believe that some dollar strength was a reaction to Catalonia wanting to secede and fears that this was the beginning of the next great European crisis. But the dollar is far from being driven by it.
The dollar’s immediate fortune was always in the hands of the ECB. But its future rests squarely with the success or failure of tax reform. It is Trump’s dollar now.