by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] Happy New Year!  We’re back…

After some profit-taking into year’s end, the first trading day of the year is starting off with a return to mid-December trends—long-term interest rates are rising, the dollar is up and U.S. equities are up as well.  The dollar’s strength is pushing gold prices lower but oil continues to trade stronger despite the rising greenback.  News that Kuwait and Oman have made production cuts in line with the OPEC agreement is supporting higher oil prices.

President-elect Trump has appointed Robert Lighthizer to the post of U.S. Trade Representative.   Like Trump’s pick of Peter Navarro, Lighthizer leans toward trade restrictions, especially against China, and is friendly toward tariffs and quotas.

One of the aspects of Trump’s trade policy that has, in our opinion, been underestimated by financial markets is the lack of understanding of the reserve currency role.  The dollar, as the global reserve currency, is used for trade transactions that do not involve the U.S.  The BIS estimates that about 80% of trade-related letters of credit are denominated in U.S. dollars.[1]  The most effective way for foreign nations to acquire dollars is by trading with the U.S.  In fact, the world needs to run trade surpluses with the U.S. so that there are ample dollars available for global trade.  This situation creates a problem; eventually, either domestic support for trade falters in the reserve currency nation due to job losses or foreigners lose faith that the reserve currency nation will maintain the value of the currency.  This problem was first identified by an economist named Robert Triffin (thus it has been described as the “Triffin dilemma”).

What the incoming administration doesn’t seem to recognize is that if the U.S. takes steps to restrict trade it will reduce the supply of dollars on global markets.  Falling supply without a commensurate reduction in demand will lead to a stronger dollar.  And, fears among foreign nations that the U.S. is going to restrict trade will actually boost demand, enhancing the effect.  Couple this policy with proposed changes in corporate tax law that would create border adjustments to tax imports and not exports and the dollar will rise further (not to mention the potential impact of a repatriation holiday).  In the face of tighter imports, the FOMC may be inclined to lift rates sooner and by more than the markets expect.  Although we always have concerns about “one-way trades,” a stronger dollar looks inevitable.

Overall, then, what does a stronger dollar bring?  It’s bearish for commodities; gold is especially vulnerable.  As noted above, oil is trading counter to the stronger dollar on expectations of OPEC supply cuts but, in general, dollar strength is negative for commodities.  Dollar strength is a profoundly bearish factor for emerging market equity and debt; dollar strength has been behind emerging market economic problems since currency floating began.  For developed markets, it’s something of a wash.  The weaker foreign currencies act as a form of policy stimulus, which is bullish for equities in local terms, but the unknown for a U.S.-based investor is whether the dollar strength will offset the equity market rally.  In the U.S., small and mid-caps tend to benefit on a relative basis to large caps because the latter have more foreign exposure and thus earnings for large caps are at greater risk.

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[1] http://www.bis.org/publ/cgfs50.pdf, especially page 13.