FX: Protectionist risk premium in the US dollar

The year has started strongly for risky assets – especially equities. The theme of synchronised global growth, re-rating stories outside of the US and dollar weakness is now a familiar one. We have characterised this as a ‘benign decline’ in the dollar and it is on this which we base our year-end EUR/USD forecast of 1.30.

Yet over recent weeks, we have also seen the emergence of some less benign factors such as US protectionism and a mercantilist approach to dollar policy. We now expect investors to build a protectionist risk premium into the dollar, prompting us to revise our USD/JPY forecasts lower.

Let’s look at the two key developments here:
(1) President Trump agreeing to anti-dumping tariffs to protect US manufacturers of washing machines and solar panels; and
(2) Treasury Secretary Mnuchin’s comment that a weaker dollar is good for trade.

Both developments could be dismissed as ‘noise’. We would counter that:
(1) this is the first time these particular safeguard tariffs have been used since 2002; and
(2) President Draghi did not regard Mnuchin’s remarks as casual and instead publicly rebuked him for seemingly encouraging a weaker dollar for trade gain.

In particular Mnuchin’s remarks recall a very similar (and failed) dollar policy employed by the US Treasury in the early-1990s. At the time it was seeking to narrow the US trade deficit with Japan. Having encouraged a weaker dollar in 1993/early-1994 and inadvertently contributed to a Treasury market sell-off, it took well over a year for the Clinton Administration to put the genie of a weaker dollar back into the bottle – and what we now know as the US Treasury’s strong dollar policy was born in April 1995.

How much could the risk premium damage the dollar? Back in the early-1990s, USD/JPY traded more than 30% below ING’s fair value estimate based on medium-term fundamentals. That fair value calculation now stands at 105 – suggesting our downwardly revised year-end target of 100 is not particularly excessive. It also reflects the fact that the world economy is now in a lot better shape than the early-1990s.