Wednesday 12 December 2018

Lee Evans: 'US midterm elections could derail dollar and cause significant upheaval'

Ammar Campa-Najjar (D-CA), who is running for congress in California’s 50th District, addresses supporters during a campaign rally
Ammar Campa-Najjar (D-CA), who is running for congress in California’s 50th District, addresses supporters during a campaign rally

Comment: Lee Evans

October saw the US dollar post its biggest monthly increase in over two years, with the currency now trading close to yearly highs versus the euro.

This follows an almost 10pc gain since the beginning of February.

On the other side of the Atlantic, Europe is facing political challenges across a number of fronts, with some serious questions around Brexit and ongoing developments in Germany and Italy.

For Irish businesses, this all presents some equally serious questions - are we likely to see a continuation in dollar strength or should they look to take advantage of these weaker euro levels?

From a fundamental perspective, the US economy is still running hot; the latest GDP data came in at a robust 3.5pc, unemployment is at the lowest level since the 1960s when conscription for the Vietnam War shrank figures, while inflation is closely tracking the Federal Reserve's target.

The US Federal Reserve has hiked interest rates eight times since the end of 2015 and is expected to raise rates again in December.

Further increases next year also look likely, given the recent confidence on display from members of the Fed.

The question on everyone's mind is this - does this largely anti-consensus dollar rally still have legs? And if so, for how long?

Across Europe, Brexit negotiations, Italian budgetary discussions, and - with Chancellor Merkel's recent announcement - the end of an era in German politics all weigh on euro investor sentiment.

However, the US is not without political risk of its own and there could be a major headwind for the dollar in the coming week as the electorate head to the polls for midterm elections.

The result of these midterms will have broad social and economic ramifications. Therefore, the outcome has the potential to mark a significant turning point for the US dollar.

There are three main scenarios for the midterm elections, the most likely of which is a Republican majority in the Senate, while the Democrats take control the House. Opinion polls currently indicate a high probability for this outcome.

If the Democrats do win the House, a more divided government could significantly limit President Donald Trump's ability to implement new policies, while it may precipitate financial markets beginning to price in a Democratic victory for 2020 (which would likely see a reversal of some of Trump's policies, including the tax package).

If this turns out to be the case, the dollar is likely to weaken over the coming months as the narrative surrounding further fiscal stimulus is likely to recede.

The second, less-likely scenario would see the Republicans win both the House and Senate which would give Trump political stability for the next two years, improve the President's negotiating power and further support the administration's domestic policies; this would combine to give the US currency a very strong boost and would almost certainly see new highs for the dollar against the euro.

The final scenario that could occur would be the Democrats taking both the House and the Senate; this would signal an extraordinary shift in the US political backdrop and likely lead to an increase in volatility. The political standstill and uncertainty would see the dollar depreciate and an increase in volatility across all financial markets.

We don't have to the look too far back to analyse how US politics can affect the currency.

The US presidential election of 2016 caught financial markets off-guard and the initial reaction of dollar-selling was quickly reversed as markets began to price in campaign promises of pro-growth policies, fiscal spending and tax cuts.

This saw the dollar gain over 5pc against the euro over the following six weeks. The dollar's fortunes began to turn around the time of President Trump's inauguration, as the new administration vaguely indicated that a strong currency may not support the economy and the euro rallied in the subsequent months.

Similarly, the dollar's path for 2019 could well be dictated by the outcome of these midterms.

Looking beyond the immediate elections, there are other risks for the dollar on the horizon.

The US budget deficit continues to widen, as does the trade deficit, while President Trump's increase in fiscal spending has come as the US approaches the end of the business cycle.

The strong currency is also unlikely to please Trump, especially as the US administration has focused on the trade deficit with China and, in particular, the Chinese currency.

For Ireland, the US remains one of our main trading partners with figures for 2017 from the Central Statistics Office showing that 25pc of our exports go to the States, while the US accounts for 17pc of our imports.

There are also a number of American companies with an Irish presence who naturally have both business and employee interests in the value of the dollar.

Finally there is a clear link for our tourism sector - Irish shores have long been a favoured destination for US tourists and the strong dollar has made holidays here even more affordable in recent months.

Despite the relatively low levels of the euro, we've seen a muted response from Irish businesses with limited amounts of hedging, however this could change in the coming weeks.

A major turning point in the dollar can have far-reaching implications for financial markets and businesses alike.

Are we about to see another one?

  • Lee Evans is Head of FX Strategy, Bank of Ireland Global Markets

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