Currency markets are increasingly turning to U.S. fiscal and trade policies as the factors most likely to shape the U.S. dollar’s direction in 2017. Many have said a protectionist approach to global trade will be positive for the greenback based on boosting exports and reducing imports. A few historical and present-day realities suggest otherwise.
At the core of Donald Trump’s protectionist foray lies his plan to cut income tax rates and slash corporate taxes from 35% to 15%. These will be financed by the border adjustment tax, designed to tax U.S. importers and remove any levies on exporters, thus aimed at boosting U.S. manufacturing. The proposal faces staunch opposition from retailers, oil refiners and automakers whose products contain a high level of imported content, thereby raising prices on U.S. consumers. What kind of surge in labor and input costs would that pose on U.S. importers? This is a question for their shareholders and their workers.
The proposed tax cuts are estimated to add $7.2 trillion to the national debt over the next decade. This implies the return of the U.S. budget deficit among the high profile red flags in USD fundamentals. The deficit bottomed to 2.6% of GDP in 2001 before worsening to a cycle peak of 3.8% of GDP in 2004. The deficit then improved to -1.0% of GDP in 2007 before rising to 10% of GDP in 2010. It finally dropped back to -2.2% in 2016 and is now at 3.1% of GDP. Each of the lows in the deficit coincided with a peak in the USD Index. This suggests that the highs in the USD seen earlier this year comprise a major top in the currency. That would especially be the case as the rest of the world begins to scale back their policy easing and/or tightening as inflation rates move higher.
What about the rest of the world? The European Union and other U.S. trading partners are already preparing the groundwork for a legal challenge to the border tax proposal in a move estimated to be almost 100 times greater than the largest World Trade Organization (WTO) lawsuit to date. And if president Trump goes on with his threat to ignore the WTO ruling, a global trade war becomes much more than a theoretical possibility.
Don’t expect U.S. trading partners to sit quietly by. Indeed, the notion that Trump’s planned protectionist measures (tariffs and border adjustment taxes) will be USD-positive is predicated on an unrealistic world view in which Mexico, China and other U.S. trading partners would just sit back and watch without any retaliatory action. We are no longer in the 1980s or 1990s when U.S. trading partners operated in a closed world, unaccountable to any global free trade bodies. U.S. trade actions are no longer going unanswered. The most recent example was when the George W. Bush administration had to reverse the 2001 steel tariffs after the EU threatened to target Florida’s orange juice and Detroit’s autos. Imagine what the Chinese could do today.
Since the 1990s, currency traders have consistently sold the U.S. dollar at each occasion where the U.S. adopted protectionist measures (Reagan vs. Japan in 1983-84 and George W. Bush with foreign steel).
It is no surprise that Bush’s war declaration on foreign steel in late 2001 aimed at saving the bankrupt Rust Belt in order to boost his mid-term election chances coincided with the peak of the USD bull market in February 2002. By the time the WTO fined the United States $2 billion in sanctions, the U.S. dollar had lost 12% before falling into a seven-year bear market.
We have most likely seen the top in the U.S. Dollar Index while any attempt to retest the 103.80s highs will be an invitation to sell.