What could squeeze the US dollar much higher?

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In trying to forecast currencies, it is often useful to look back at periods in the past when seemingly similar situations existed. But we should certainly not be over-reliant on historical comparisons, and hence we will also explain why the outlook now might not play out in the same sort of way as we’ve seen before.

In the Standard Bank’s opinion, there are two factors that could act together to squeeze the US dollar higher. The first is a second Trump presidency, and the second is the threat of a balance sheet recession in China. On the first of these, it might seem as if the obvious historical comparison is the first Trump presidency from 2017; a period that did, at least initially, see the US dollar rise notably before falling back. But while that’s a decent guide, we think that there are other issues going on at the moment that mean that a longer-term historical comparison might be more appropriate.

We are thinking about the early 1980s, as we have discussed before, when the tax-cutting Reagan presidency collided with the inflation-fighting Fed. The upshot was a period of high US yields and dramatic dollar strength, with the dollar’s real effective exchange rate rising by more than a third between 1980 and 1985. Fast-forward to today and former President Trump plans an extension of tax cuts if he wins in November while other policies such as much higher tariffs and illegal migrant deportation could add to inflationary pressure and so keep US rates relatively elevated (unlike 2017 when US rates were low).

Geopolitical tensions today are more like the cold war period between the US and Russia in the early 1980s than Trump’s first term and, if these tensions escalate during a second Trump presidency, it could create a premium in the US dollar that puts it more on a path towards the scale of rally we saw in the early 1980s than the more modest – and temporary – rise that we saw after Trump won in 2016. But it is not just the possibility of bullish US dollar developments in the spheres of US politics, monetary policy and geopolitics.

On the flipside, there are risks of weakness outside the US that could exacerbate US dollar strength. One issue on this score is the weakness in China’s economy and, more specifically, the risk that the country has – or will – fall into a balance sheet recession largely as a result of the weakness in the real estate market. The historical comparison here is seemingly Japan’s decent into a balance sheet recession in the 1990s after its housing market (and stock market) cracked. While this did not initially create significant yen weakness, the whole period from the mid-1990s through today has seen the yen fall significantly, with the real effective index worth around a third of what it was in the mid-1990s.

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Now clearly there are lots of reasons why things might not be the same for China today, not least the fact that the PBoC has effective control over the renminbi’s value that the Bank of Japan has never had for the yen. Nonetheless, if we look at the decline in inflation and Chinese bond yields, for instance, there does seem to be some evidence that balance sheet recession type forces could be at work.

And if this yield weakness grates against pressure for higher yields in the US following a Trump victory, the strains on the renminbi could not just become harder to bear, but could have an adverse spillover to other currencies against the US dollar, particularly Asian emerging market currencies which are already under pressure from yen weakness.

“We said at the top that the confluence of these two factors; one from the US and the other from China, could produce a much stronger US dollar. But we also have to consider why this might not happen. For instance, currencies generally seem more stable these days than the 1980s and 1990s and there are mechanisms, such as central bank swap arrangements to help ease tensions as well. But, while we might doubt that the scale of the US dollar’s moves in the 1980s will be repeated, the direction could prove the same,” said the Standard Bank.