Why the USD will go on rising

The US Dollar Index is down a good 3%, to 99.9 on January 25 from a high of 103.3 on Dec 28. The main reason is uncertainty over the future of trade and international relations with the US.

Since taking office on Jan 20, President Donald Trump has already yanked the US from the Trans-Pacific Partnership, called for renegotiations to terms of the North American Free Trade Agreement and will soon order the construction of a Mexican border wall.

The moves ring true to Trump’s campaign promises and have forced the market to view the new POTUS in a different light. Now, Trump’s threats of starting a trade war with China and public comments on the USD being overly strong are being taken seriously, and that’s put pressure on the currency.

Yet, analysts and strategists view the dip in the USD versus the Japanese yen, euro and even gold as a temporary blip in an ongoing USD bull run that is expected to continue for the next six months or more. Here are some reasons why:

#MAGA – In a series of tweets, the POTUS has repeatedly made claims of “Making America Great Again” on his now famous Twitter account. Based on his campaign promises and actions so far, this could involve a massive infrastructure spending program, keeping jobs within the US and deregulating the finance and energy sectors.

That could offset the downward pressure on the USD and eventually drive the currency higher. “Trump’s moves are expected to revive and stimulate the US economy, which will then stoke inflation [and] give the US Federal Reserve [better] headroom for more frequent interest rate hikes this year,” says Woon Tian Yong, investment analyst at Phillip Futures.

Fed tightening – With inflation just 0.2% shy of the Fed’s 2% target in Oct 2016 and the unemployment rate at a low of 4.6%, the Fed has already raised rates once in Dec and signalled that three more rounds of hikes are on the cards this year.

However, a strong USD will weaken the manufacturing and export sector and eventually reduce inflation. Could this stay the Fed’s hand when it comes to raising rates?

Last week, former Fed chair Ben Bernanke told a Singapore audience that “as long as the economy is improving and running close to full employment and the 2% inflation target, the Fed will allow the USD to do whatever it wants to do.”

Heng Koon How, senior investment strategist, Asia Pacific FX, at Credit Suisse, reckons the strong US economy and Trump’s domestic policies will likely spur the Fed into tightening its monetary policy further this year.

That will add more strength to the USD, particularly against the renminbi and Singapore dollar, which are forecast to reach 7.30 and 1.48 this year.

Monetary policy divergence – The Fed may be on a tightening path, but it is still the only major central bank doing so at the moment.

On Jan 19, the European Central Bank kept its main interest rate unchanged at zero.  Last month, it also said that it would extend its bond-buying program, which had been due to end in March, until at least Dec this year.

Meanwhile, the Bank of Japan is also expected keep its easy policy. “BoJ Governor Kuroda has clamped down on any talk of tapering and there are few developments suggesting that he will suddenly change that stance,” says Shusuke Yamada, FX and equity strategist at the Bank of America.

He adds that if US economic data remains strong, the market will start pricing in a greater probability of a March rate hike, triggering greater long term positioning in the USD and driving the currency up. This divergence in monetary policy between the two central banks should boost the USD/JPY to 120 this year, says Yamada.

Market belief – David Bloom, global head of FX strategy at HSBC, says: “Politics is the new economics when it comes to predicting foreign exchange movements. When Shinzo Abe became the Prime Minister of Japan, inflation did not pick up, yet that didn’t stop the yen going from 80 to 125 against the USD.”

That same market bullishness will drive the USD much higher against other currencies over the next six months. “The market still believes that inflation will pick up as the US economy picks up under Trump. You don’t want to stand in the way of the USD when financial markets are in this belief stage.”

Bloom forecasts a further 5%-7% appreciation in the USD versus other currencies until end-June, after which the currency’s rally should start to taper.

This article first appeared in The Edge Singapore Market Report.

The Edge Markets helps its readers to make better business and investment decisions by empowering them with the latest financial news, data and analytics. The Edge Markets is part of The Edge Media Group.

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