investment insights
Election risk in the driving seat for the US dollar
Key takeaways
- Political risks could drive the US dollar higher in the months ahead
- Dollar strength is underpinned by domestic growth and yield advantages. The bar looks high for material weakness, despite some convergence between the economic prospects of the US and those of the rest of the world
- A Trump presidency could extend support for the dollar, given proposed tariffs, tax cuts and immigration policies; a second Biden term and split Congress could be somewhat negative for the dollar
- We judge US fiscal risks to be manageable for the dollar and supportive for gold. We retain a positive dollar outlook, and our three-month EURUSD target of 1.04, but lower our 12-month target from 1.08 to 1.06.
Political risk will be an important dollar driver in the months ahead. We see ongoing US dollar strength against the euro and sterling and examine the likely impacts of different US and French election outcomes.
A chapter of elevated political risks, culminating in the November US elections, threatens volatility in markets. Periods of uncertainty are a boon for the US dollar, which tends to gain ground as investors seek havens from the storm. Currently, investors’ dollar positions are low, but we expect these to rise amid political risk in Europe, and as the US presidential race approaches. This should push the dollar higher, especially against the euro and sterling.
If the second round of French elections on 7 July results in a majority French government led by the far-right Rassemblement National or a majority far-left government – neither being our base scenario – we could see EURUSD trade nearer 1.02. This is below our three-month target of 1.04 for the currency pair. In such an event, we would expect a reversal of recent large portfolio inflows into the euro area. We would also expect any spike in geopolitical tensions to provide a boost for the dollar.
By some measures – and in Donald Trump’s eyes – the dollar is already strong. Against a basket of other currencies it remains higher than for most of the last decade. This year, its resilience has been striking amid a positive market backdrop. Usually, the dollar tends to weaken when risk sentiment is strong and rise on signs of trouble.
‘Push’ and ‘pull’ factors for the dollar
Capital flows from the US to the rest of the world are an important determinant of dollar movements. Lower US interest rates reduce the opportunity cost of keeping assets in the US, and become a push factor for capital outflows. At the same time, better growth prospects abroad can become a pull factor for capital to flow from the US to other markets.
US interest rates are the highest in the G10 and are expected to remain so over a two-year timeframe. This should maintain a high bar for capital outflows. While central banks in the eurozone, Switzerland, Sweden and Canada have started cutting rates, and the UK should do so in August, we do not expect a rate cut in the US before September. Even after these rate-cutting cycles are over, we estimate the ‘neutral’ rate of interest in the US to be around 3.5%, higher than in many other developed markets. This should provide an anchor for the dollar.
A lot depends on China
Over both 2023 and 2024 to date, consensus US growth estimates have been continually upgraded, while those for the euro area and China have remained lacklustre. In prior cycles, reflationary Chinese policies were a key driver of better global growth prospects, but this time, such policies have not materialised.
And while the gap in US versus global growth is narrowing as Europe recovers and China stabilises somewhat, ‘US exceptionalism’ is underpinned by several structural strengths, including a capital expenditure boom, rising productivity and the shift to being a net energy exporter. This suggests that the dollar may be less expensive than commonly believed. A multipolar world, with increased competition and trade barriers between rival blocs is also proving positive for the dollar for now.
What could derail dollar strength?
The bar looks high for any material dollar weakness, although negative US data releases could see short-term corrections and are one reason for recent rangebound trading against the euro. A big downgrade of US growth expectations could initially drive the dollar lower, but we still expect a soft economic landing. So could a pronounced global growth rebound, but this looks unlikely given a lacklustre China outlook. A third driver would be a sharp fall in energy prices: in our view also a limited risk.
US elections and the dollar
The outlook for the dollar beyond November will of course depend on the US election outcome. Markets are already starting to price in the potential impacts and weighing fiscal risks.
In the event of a second Trump presidency – which is looking increasingly likely – we see a more inflationary environment and dollar gains from three potential sources. The first would be a blanket imposition of tariffs on all US imports, which could be done by executive order, placing trading partners at a competitive disadvantage, and weakening exporter currencies. We estimate that 10% tariffs could increase inflation by a minimum of 1% over the course of a year, reducing the scope for interest rate cuts in 2025.
The second would be the extension of existing tax cuts, boosting growth, or the possibility of trying to enact new ones. The third would be stricter immigration policies, which would keep the labour market tightly balanced. We would see any move to impinge on the Federal Reserve’s independence under a Trump presidency as negative for the dollar.
If President Biden wins a second term, we see a split Congress as a likely outcome, a more neutral to negative dollar scenario. In this case, we see no major change in tariffs and trade tensions. Fiscal policy would likely become slightly less expansionary, with the possibility of tax hikes taking some of the shine off US growth. The Democrats could also seek more measures to control immigration, but we would expect the risk of labour shortages and inflationary effects to be more contained.
Assessing fiscal and political risks
In other countries, political and fiscal risks hurt currencies and risk assets. French stocks have suffered amid current political uncertainties. Sterling slumped after the announcement of unfunded UK tax cuts in September 2022. To date, the dollar has been largely immune to concerns over acrimonious politics and rising federal debt. There is little appetite from either party to tackle the latter. The Congressional Budget Office estimates the federal deficit will double in this tax year from 2019’s level. Next year, it could increase further to finance either the continuation of tax credits from the Inflation Reduction Act and related healthcare budget, or tax cuts enacted by President Trump in 2017.
Gold implications
This could raise demand for other haven investments but may not be a determining factor for the dollar. We see some mitigating factors to fiscal risks. The growth rate of the US economy exceeds the interest rate on US sovereign debt, allowing a modest fiscal deficit to be sustainable. The current account deficit remains contained and corporate and household balance sheets healthy. The US could also raise taxes, which are low relative to GDP. Historically, events in the rest of the world have tended to matter more for the dollar than domestic dynamics: a higher real rate on offer in the US also partly compensates for domestic risks.
Longer-term, we would view moves by countries not aligned with the US to lower their economies’ dependence on the dollar as a supportive factor for gold. Increased central bank reserve allocations to gold should help prices rise towards USD 2,600/oz in the coming year. However, such ‘de-dollarisation’ trends are slow moving and need not result in a dollar collapse. For now, the dollar retains its privilege as the world’s reserve currency and its dominant role in global trade and finance.
With the dollar remaining a haven investment with high yields, and with few signs of a boom in other major economies, it makes sense to own dollar exposure – although of course we monitor the risks. We see the euro-dollar exchange rate trading at 1.04 in three months and 1.06 in twelve months. Importantly, we do not see a meaningful dollar depreciation that would outweigh the yield advantage of holding dollar-denominated assets.
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