The dramatic ascendance of Donald Trump as the apparent Republican nominee mid-week was been accompanied by a 0.4% rally in the Bloomberg dollar index (BBDXY).
Is that a coincidence or is Trump’s rise the cause?
My answer to that question is: it’s complicated. I think the US political news is responsible for at least part of that USD rally.
And I think that Trump winning the election would prove to be USD positive over the medium term for several reasons, although again- it’s complicated.
Trump’s victory probability
Everyone has an opinion on whether Trump could or could not actually win a general election, but markets need to rely on hard data.
My three favourite sources of hard data for this election are the following:
RealClear Politics average of head-to-head polls has Trump lagging behind Clinton for all of 2016.
The narrowest gap (mid January) was 1.8%, while the widest gap has been 11.2% in late March. The gap has been narrowing over the past six weeks and presently stands at 7.3%.
This is simply an average of polls, though, so it doesn’t take in to account the stratification that results from the US’s Electoral College system.
Although the Electoral College helped a Republican (Bush) win the presidency in 2000 despite losing the popular vote, it has been much kinder to Democrats over the past 3 elections.
For example, the 2012 popular vote was 51% for Obama to 47% for Romney, but the electoral college as 332 votes (62%) for Obama to 206 (38%) for Romney. In the 2008 election, Obama got 68% of the Electoral College votes vs 53% of the popular vote.
This shows how important it is to keep the electoral “map” in mind.
Larry Sabato of the University of Virginia’s Center for Politics is one of the foremost electoral “map” experts.
He did a detailed state-by-state analysis of a Trump vs Clinton race and came up with a prediction of 347 for Clinton vs 191 for Trump. His underlying assumption was that Republicans will eventually coalesce around Trump, while Democrats will coalesce around Clinton as the race draws near.
Markets seem to agree with Sabato. The oft-cited Iowa Futures market has the latest price implying about a 67% probability of the Democratic nominee winning the popular vote.
As noted above, that isn’t the question at hand. PredictIt has a contract that is specific to Trump winning the election via the Electoral College. The latest price implies a 38% probability of Trump winning.
Averaging across the two sources (despite the technical issue with the Iowa Futures contract) gives a market implied probability of Trump winning of around 35%. That is what I would go with for now. Trump’s probability of winning would presumably rise if either (1) the economy takes a turn for the worse over the next six months or (2) there is another major terrorism event before the election.
Trump and the Fed
Candidate Trump has commented on Fed Chairman Janet Yellen on several occasions. His most recent comments came in an exclusive interview with Fortune Magazine published 21-April.
In that interview, Trump said that Yellen is “doing a serviceable job” but that he “would be more inclined to put other people in” rather than reappoint her as Chairman (in January 2018).
Trump didn’t say whether he wanted the Fed to raise rates, but he did say that low interest rates are “unfair to those people who have led their lives in the way they were supposed to” (by saving for retirement).
All of the members of the current US Federal Reserve Board of Governors (BOG) were nominated by President Obama (although Stanley Fischer was a compromise nominee pushed by Republicans).
BOG members can make multiples of what the Fed pays them in the private sector. I presume that several BOG would resign within the first year of a Trump presidency and would be replaced by Republicans.
There is an outside chance that Yellen could choose to resign early and would be replaced by a Republican. On an 80/20 rule, Republicans tend to be more hawkish than Democrats, so I assume the FOMC would swing substantially more hawkish in 2017 and 2018 under a Trump presidency. In my view, this is the biggest factor for the USD and would be USD bullish if Trump were to win.
Trump and the tax code
Although it is theoretically possible that Trump could win the presidency while Republicans lose the Senate, it is a highly unlikely combination.
It is far more plausible that Republicans would control all the pillars of government and therefore be able to pass whatever tax reform they choose.
The end result would almost certainly be swift passage of a corporate tax cut. In general, corporate tax cuts tend to be positive for a currency.
Trump's website discussion of his tax reform proposal says that “No business of any size…will pay more than 15% of their business income in taxes. This lower rate makes corporate inversions unnecessary.”
It also promises a HIA2 type provision or “A one-time deemed repatriation of corporate cash held overseas at a significantly discounted 10% tax rate, followed by an end to the deferral of taxes on corporate income earned abroad.”
The last repatriation amnesty window (HIA1) in 2005 coincided with a rally of about 5% in the Fed’s broad real trade weighted dollar index.
However, it is important to note that the 2005 rally occurred in the middle of a seven-year USD downtrend. If there were to be a HIA2 in 2017, it would be in the middle of a multi-year USD uptrend and may have an even bigger impact. This is reason #2 why I think a Trump victory would be USD bullish.
Trump and trade
Trump is not a traditional Republican on trade—at least in what he has said to date.
On the campaign trail, he has repeatedly said that the WTO and NAFTA have cost the US millions of jobs and that he would renegotiate trade deals in order to end what he call “unfair trade” imposed by China in particular.
It is highly unlikely that Trump could remove the US from NAFTA or the WTO and he knows it.
In Trump's website discussion of trade, he says he would begin his presidency by immediately labelling China as a “currency manipulator” and then use that as a negotiating tool in US disputes over tariffs, market access and intellectual property disputes.
It is unclear whether Trump could really make much of a dent in the US trade deficit (and the TPP might get passed by Congress and signed by President Obama in the lame duck session). But giving him the benefit of the doubt, any reduction of the US’s trade deficit that results from negotiating more aggressively should be bullish for the USD.
The only caveat to that statement is that Trump seems to recognise that a strong USD is bad for US jobs, so he may try to talk the USD down as his policy of renegotiating down the trade deficit drives the USD higher. Over the medium term, fundamentals overpower jawboning, but this is the least important argument for Trump being USD bullish.
What Does This all Mean for the Dollar's Outlook?
We have a general rule of thumb that we use for elections. Elections tend to be negative for international debtor currencies.
This is the result of event risk hedging. Such hedging causes those who are both long and short the election currency to top up hedges.
For an international debtor like the US, there are more long-USD positions to hedge than short-USD positions.
Because of this factor, we have put a minor setback in to our USD outlook for the August-November election hedging window. We are going to stick with that outlook, but it now comes with an important caveat.
If the election takes an unexpected turn and Trump’s victory probability rises substantially during that hedging window, the USD might rally (despite event risk hedging) because the FX market would move to factor in tighter US monetary policy in 2017 and 2018 along with the strong likelihood of a HIA2 wall of capital entering the US in 2017.