Conventional wisdom in the market right now is that the dollar is only headed in one direction: higher. Many believe that the policies the new administration will ultimately put in place are undoubtedly bullish for the dollar even as weak-dollar comments are coming out of the oval office. In recent posts, we have been pushing against consensus by pointing out how cyclical stocks may be signalling a different direction for the dollar and that the dollar is overvalued against a majority of its trading partners on a purchasing power parity basis. Today, we present our readers with another chart that seems to indicate that the cyclical high in the dollar may already be in place. In the chart below, we combine the trade deficit and the budget deficit (aka the twin deficits) and plot it against the nominal trade-weighted dollar. As you can see, if we move the twin deficit series forward by 18 months, it has a pretty strong relationship with the dollar since 1995 when nominal trade-weighted dollar data is first available. Larger deficits tend to be a headwind towards dollar strength while smaller deficits are usually accompanied by a stronger dollar. Given the Trump administration’s hawkish stance on trade, it is reasonable to assume the the trade deficit may narrow. However, the budget deficit would certainly widen significantly, as we pointed out in our post-election update conference call, if Trump is able to push through his fiscal policy. Given that, it doesn’t take a great leap of faith to assume that the twin deficits could very well remain at about the same level as it currently is which should weigh on the dollar over the next several years all things being equal.
Article by Eric Bush, CFA – Gavekal Capital Blog
