Trump's Dollar Paradox Could Bring In Higher Volatility In Forex Markets

If visibility and predictability are two foundations upon which stable financial markets are built, comments from the White House this week on the US dollar suggest investors should brace for increased foreign exchange volatility. President Donald Trump and his top trade adviser waded into the debate over the currency's strength and the damage they say it is doing to US competitiveness, drawing rebuffs from Germany and Japan and casting doubt over the strength of global cooperation on foreign exchange policy.

On the one hand, this should come as little surprise. A key pillar of Trump's election campaign was to reinvigorate US manufacturing and bring back what he sees as lost jobs. A weaker dollar would be instrumental to achieving that goal.

But his desire to boost US economic growth - via tax cuts, increased spending and encouraging US firms to repatriate billions of dollars of cash held overseas - is consistent with higher interest rates and a stronger dollar. 

For global policymakers, the verbal volleys from Washington sharpen the focus on the Group of 20 leading nations' commitment to "abstain from competitive devaluations and not set exchange targets for competitive reasons".

But for investors, increased volatility looks on the cards. 

"If the administration is talking the dollar down but pursuing policies that will push it the other way, then that's a recipe for uncertainty, if not volatility," said Joseph Gagnon, senior fellow at the Peterson Institute for International Economics in Washington and former official at the Federal Reserve. 

"I see a tension between policies that will push the dollar up, and their desire for it to weaken. You could say it's a paradox, or incoherent. And it could end up in a bit of a mess," he said.

ROLLER COASTER

Trump and his top trade adviser, Peter Navarro, this week criticised Germany, Japan and China, saying the three key US trading partners were engaged in devaluing their currencies to the harm of U.S. companies and consumers. German Chancellor Angela Merkel and Prime Minister Shinzo Abe rejected the claims.

But the verbal intervention from the White House appears to be working. The dollar hit its lowest since the week after the U.S. presidential election - its index value against a basket of currencies falling to 99.35 and the euro rising above $1.08 for the first time in almost two months.

Implied volatility measured by one-month euro/dollar options, a gauge of the expected trading range over the period, has fallen back to historically low levels as the euro has moved further away from parity with the dollar. 

But Trump's election win gave a glimpse of the potential volatility his policies might induce. One-month euro/dollar implied volatility posted its third biggest monthly rise on record in November, only behind September and October 2008 in the white heat of the global financial crisis.

Analysis last year by Hyun Song Shin at the Basel-based Bank for International Settlements shows that the dollar had supplanted the VIX index, a measure of implied volatility on Wall Street, as the variable most associated with investor banks' appetite for risk-taking. 

The dollar's surge over the previous three years was potentially destabilising for the global financial system, given that dollar borrowing from non-US institutions firms and households outside the United States is almost $10 trillion.

But while a weaker dollar helps ease global financial conditions, increases global lending and contributes to market stability, as Shin's research suggests, mixed signals on Washington's position on the world's pre-eminent currency may not.

"The dollar might jump around on these sorts of comments but it won't go down for weeks and months just because of them," said Steve Barrow, head of G10 strategy at Standard Bank in London, adding that the dollar is in for a "roller coaster" ride.

"If all that mattered was policymakers comments about their currencies we'd all have been selling the Swiss franc in recent years - and lost our shirts," he said, noting the franc's record rise when the Swiss National Bank unexpectedly scrapped its peg to the euro two years ago.