Fiscal Policy and US Dollar Dynamics Post-Election

Our US Public Policy and Currency experts discuss how different outcomes in the upcoming U.S. elections could have varying effects on the strength of the dollar.

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Ariana Salvatore: Welcome to Thoughts on the Market. I'm Ariana Salvatore from Morgan Stanley's U.S. Public Policy Research Team. And I'm

Andrew Watrous: And I'm Andrew Watrous, G10 Currency Strategist.

Ariana Salvatore: On this episode of the podcast, we'll discuss an issue that's drawing increasing attention from investors leading up to the U.S. election -- and that is the U.S. dollar and how a Harris or Trump administration could impact it.

It's Thursday, August 15th at 10am in New York.

Earlier this year, Morgan Stanley experts came on this show to discuss the current strength of the US dollar, which has had quite a historic run.

Now we all know there are numerous ways in which politics could affect the currency. But before we get into the details there, Andrew, can you just set the stage here a little bit and give some context to listeners on where the dollar is right now and what's been driving that performance?

Andrew Watrous: Yeah, the dollar's been rising this year. So, if you look at a trade weighted gauge of the US dollar, it's up about 3 percent, so far. And part of that US dollar strength is because growth expectations for the US have risen since January. There's a survey of Wall Street economists, and if you look at their median forecast for the US growth, it's moved up about one percentage point since January.

And as a result of that strong US growth, we've seen Fed policy expectations move higher. We started this year with the market pricing the Fed to be below 4 percent by December. And that expectation for where the Fed is going to be in December has moved up about 1 percentage point since January.

So, robust US growth and a higher near-term Fed policy rate expectation have made the US more attractive as an investment destination. And that's boosted the US dollar broadly as capital flows to the US.

Ariana Salvatore: That makes sense. Now, thinking about the balance of the year, it's impossible to look ahead and not consider how the US election could impact or change this trend that you've been talking about. As we get closer to November, investors are also starting to question just what will happen to the dollar in a Republican or Democratic win. What's been our approach to thinking through that question?

Andrew Watrous: So, if you look at policies proposed by the Republican presidential campaign, a number of those policies, if implemented, would probably boost the US dollar.

First, higher tariffs on goods imported from our trading partners could weigh on expectations for growth abroad. That would make the US more attractive in comparison, maybe send capital to the US as a safe haven due to policy uncertainty. And of all the scenarios we look at, we think that one where the Republicans control both Congress and the White House would be the scenario in which the federal government spends the most and issues the most debt.

More spending would likely make US growth expectations and bond yields higher in comparison to what we'd see in the rest of the world. So, a Republican presidential administration could attempt to offset some of that US dollar strength; but in the near term we think that the US dollar should go up if a Republican White House looks increasingly likely. And on the other side, the dollar could go down if the likelihood of a Democratic White House looks increasingly likely -- as some positive risk premium around trade and fiscal policy is reduced.

Ariana Salvatore: Okay, so you mentioned quite a few policy variables there. Let's take those issue areas one by one. On trade policy and geopolitical risk, it wouldn't surprise us from the policy side to see a potential Trump administration introduce tariffs, just given the rhetoric we've seen on the campaign trail. We've talked about the potential impact from 10 per cent universal -- targeted or one-for-one tariffs -- which all come with varying degrees of economic impacts.

On the currency side, Andrew, walk us through your thought process on how the risks to growth expectations from tariffs could factor into dollar positive or negative outcomes.

Andrew Watrous: So, a lot of our thinking on this is shaped by what we saw in 2018 and 2019, when there were trade tensions. During that period, the dollar moved higher, starting in spring 2018 until the end of 2019, and a big part of that dollar strength was probably due to trade tensions between the US and China. Those tensions meant that investors were probably more hesitant to take on risk outside the US than they otherwise may have been. That's why the US dollar kept rising during that period, despite the Fed cutting rates three times in 2019. And in 2018 and 2019, we saw expectations for growth in countries outside the US moving lower -- in part because of trade tensions during that period.

So, from speaking to my colleagues in the economics department here at Morgan Stanley, it seems pretty plausible that something similar happens to expectations for growth outside the US, again, if another trade war looks increasingly likely. And that drop in what people expect for growth outside the US would probably boost the US dollar as the US looks more attractive in comparison.

Ariana Salvatore: Got it. Now, shifting gears slightly to the fiscal policy outlook. We've said that the Republican sweep outcome is the most likely to lead to the greatest degree of fiscal expansion, and that's because we think lawmakers are going to have to contend with the expiring Tax Cuts and Jobs Act. We think that in a divided government outcome, or a Democratic sweep, some of those tax measures are still on the table, but it'll probably be a narrower extension from a deficit standpoint.

So, Andrew, what would a fiscally expansionary regime mean for the dollar?

Andrew Watrous: So, as you mentioned, the most fiscally expansionary scenario would be a Republican sweep scenario. And we did some research into capital flows; and the Treasury data show that historically, higher US spending is associated with net inflows of private capital into the US. And if you look at the pace of US spending versus the pace of spending in Europe, if you look at that differential -- that differential is positively correlated to movements in Euro. So faster US spending means lower Euro relative to spending in Europe.

Ariana Salvatore: So, we expect that a Republican administration's policies might strengthen the dollar in summary. But it's possible that they don't like that dollar strength. We've heard Trump talk about the benefits of a weaker currency for exports, for example. So, what might a Republican presidential administration try to do to maybe offset some of the strength?

Andrew Watrous: Yeah, so if we’re right and the Republican policies do strengthen the dollar, that Republican administration could try to offset that dollar strength with a number of policy tools. And those might be effective in weakening the US dollar against one or more of our trading partners. But we don't think that the market expectation of those dollar negative policy options would fully offset the effect of other Republican policies, which would boost the dollar.

There are legal, logistical, and political challenges associated with a lot of those dollar negative policy options. So, for example, former US Trade Representative Lighthizer has reportedly expressed doubt about the viability of broad international coordinated intervention against the US dollar. He said that no policy advisor that he knows of is working on a plan to weaken the dollar. And former President Trump reportedly rejected a 2019 proposal to intervene against the dollar from former White House Trade Advisor Peter Navarro.

Ariana Salvatore: Got it. So, sounds like we have a lot of moving pieces here and we will keep refining our views as we get some more policy clarity in the coming months. Andrew, thanks for taking the time to talk.

Andrew Watrous: Great speaking with you Ariana.

Ariana Salvatore: And thanks for listening. If you enjoy thoughts on the market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.