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US Dollar at Risk of Falling Further in Late Summer as Political Risks Mount

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The Dollar is at risk of weakening during the late summer as US political and geopolitical risks ratchet up, says Bank of America’s FX strategist David Woo.

Not only the Dollar but other so-called risky assets like equities and emerging market asset, could also suffer, as political standoffs dominate politics in the US and geopolitics in a Korea-China-US relationship triangle.  

The market is not currently sufficiently alive to the notion that either of these presents a tangible risk, although positioning on the Dollar is the most bearish it has been since 2009 so its arguable the ‘smart money’ may be engaging.

The Washington standoff is likely to take the form of a ‘game of chicken’ between the Republican controlled house of representatives (GOP), the Senate, and the president over the President’s proposed tax cuts and whether they can be afforded without raising the debt ceiling.  

A similar ‘game of chicken’ is likely to begin between the west and North Korea as the US establishes a greater military presence in South Korea and puts pressure on China to control its delinquent neighbour.

The classic ‘game of chicken’ describes a game where two truck drivers are driving at each other head-on; the winner is the driver who keeps his nerve the longest and does not veer out of the way. If neither veers and they collide both die, and therefore also lose.

Woo’s point of using the ‘game of chicken’ analogy is not to forecast which side is more likely to ‘win’ but rather that the game leads to a ratchetting up of uncertainty and tension to a crescendo, which in financial markets creates the potential for extreme volatility and wrecks risk appetite.

This has led Woo to forecast a collapse in risk appetite during the late summer when these issues reach a head.

Financial market volatility is at an ultra, 10-year low, which suggests an extreme has been reached. This increases the chances of a ‘snap back’ in volatility higher from the extreme lows.  

The increased fear factor is expected to depress the Dollar as well, as it will make the Federal Reserve reluctant to raise interest rates, at least at the relatively brisk pace currently expected by markets.

The root cause of the stand-off in Washington is the failure of President Trump to repeal the Affordable Health Care Act and replace it with a cheaper reform, the savings from which would pay for tax cuts.

This was his plan, but the idea of repealing an act which provides care to the widest number of American’s in history, for a policy which will drastically cut the number of Americans qualifying for healthcare cover is too repugnant even for some Republicans to stomach, and so far Trump has failed to get a majority to vote the bill through. It now seems highly unlikely he will ever succeed in doing so.

The savings from the repeal of the Affordable Care Act were earmarked for use to fund tax cuts so that they would be of zero cost, however, now that this is not possible, Trump will have to find the money from somewhere else.

Since no savings appear to be forthcoming from other departments he will have to borrow to fund the tax cuts - and it is here that he parts ways from many Republicans who do not agree with increasing borrowing.

The US has already reached and lifted its debt ceiling once under the Obama administration and that was only agreed with great reluctance, for Trump to ask the same, risks the same response.

If the house will not vote through an extension of the ceiling there is a risk of a government shut-down in October due to lack of adequate funds, Woo explains:

“In September, Congress will have to reach an agreement over the fiscal year 2018 budget to avoid a shutdown. Around the same time, Congress will have to raise the debt ceiling to avoid a default by mid-October. A potential shutdown and/or default may be the only levers the President has over tax reform before it becomes too late.”

Thus, a fiscal drama is very much on the horizon in US politics, which is likely to lead to a ratchetting up of political risk and a continued decline for the Dollar.

North Korea

Another source of pressure for the Dollar and risky assets in general, which could come to a head at the same time as the US debt ceiling issues mentioned above, is the risk of a stand-off between North Korea, China and the US over the threat North Korea poses to global peace.

By Trump’s own admission a crude deal appears to have been made with the Chinese by which the US relents from prosecuting a trade war if  China helps keep Pyongyang under control.

“The approach of the new administration in Washington until now has been to pressure China to bring North Korea under control.

After the meeting between President Trump and President Xi at Mar-a-Largo in April, Trump tweeted that "Why would I call China a currency manipulator when they are working with us on the North Korea problem," implying that a deal had been made,” said Woo.

In reality, however, China has not done enough to keep North Korea in check, exemplified by the firing of an inter-continental cruise missile by North Korea on July 4, as a ‘gift’ to the US, on its ‘birthday’.

China has also increased trade with North Korea to the extreme annoyance of the US.

“It seems reasonable to assume that unless China begins to take more concrete actions against North Korea, the US will have no choice but to increase pressure on China. We see this situation as very similar to the tax reform showdown discussed earlier. Indeed, we think the hypothetical game we came up with to describe the latter is equally relevant for understanding the US-China conflict.”

In the same way, BofA expects the rise in risk aversion to lead to weakness in the Dollar.

They recommend trading the USD/JPY pair using a straddle option strategy which will also generate profits from the increase in volatility, to profit from these expected events.

Woo suggests buying a JPY call option which will appreciate if the yen rises and a USD put option which will appreciate if the Dollar weakens.

The Yen is expected to rise significantly if geopolitical or even US political risks emerge as it is a known international safe-haven.

 

 

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