The policies of Donald Trump and the statements of the head of the Ministry of Finance, Stephen Mnuchin, collapsed the dollar, and after that many market participants, and even world leaders, began to express their concern.
In early 2017, shortly before the presidential inauguration of Donald Trump, a survey of fund managers conducted by the Bank of America Merrill Lynch (BAML) showed an increased belief in a stronger dollar. But their expectations were not met.
The trade-weighted dollar exchange rate over the past year fell 9% against other major currencies.
The effect of exchange rate depreciation on inflation is not very felt in the US, simply because more trade contracts are held in US dollars than in any other currency.
A 2015 study found that 93% of US imports are in dollars.
According to the study, "a 10% fall in the dollar against the currencies of its trading partners will increase CPI inflation over two years by 0.4-0.7 pp."
The study showed that if the dollar falls, US exports become less expensive, while other countries' currencies depreciate. The result is an increase in premiums, profits and consumer inflation.
It is not clear what the Trump administration thinks about this. At the recent World Economic Forum in Davos, Finance Minister Stephen Mnuchin said: "Obviously, a weak dollar is beneficial to us because it is directly related to trade."
And although the rest of his speech was more nuanced, it is extremely unusual for a person in his position to move away from the “strong dollar” line. Naturally, after this speech, the American currency rushed down.
Then, Trump made a statement about the preference for a strong dollar in the long run, which caused a rebound.
Since only in April last year, the president spoke about the “overly strong” dollar, the markets were at a loss.
Conflicting signals come from other senior members of the Washington administration.
Confusing the situation and the desire of the White House to eliminate the trade deficit.
A recent tax cut package (through increased demand) is likely to lead to an increase in imports and an increase in deficits.
The trade deficit tends to decrease during a recession, but this is not a desirable outcome.
Thus, a significant reduction in the value of the dollar will be required in order to reduce the deficit, while maintaining the current high pace of the economy.
If the dollar goes into one of the long periods of weakness, such as in the late 1980s or early 2000s, how will this affect the financial market?
Much will depend on the reasons for the weak dollar. If weakness is associated with unimportant news about the US economy, then this is usually bad for stocks and good for government bonds.
The opposite will happen if weakness reflects a boom in emerging markets; this would be a sign that investors are taking advantage of opportunities in other places.
The current weakness of the dollar, apparently, is associated with the restoration of the global economy.
It also explains why stock markets started 2018 in high spirits. A weaker dollar is helping US multinationals, as Mnuchin pointed out.
This not only makes their exports more competitive, but also increases their foreign income in dollar terms.
According to BAML data, in the fourth quarter, 68% of companies with a high share of foreign sales exceeded analysts' forecasts for profit and sales.
Only 39% of companies without an international presence were able to achieve the same result.
Despite rising stocks, Treasury bond prices are falling (in other words, yields are rising).
This may indicate that foreign investors need a higher return in order to convince them to invest their money in a depreciating currency.
Another explanation: investors in US bonds believe that more rapid economic growth will ultimately lead to higher inflation, and therefore higher yields are needed to compensate.
What about the rest of the world? A weak dollar means a strong euro, which leads to a tightening of financial conditions in Europe.
The head of the European Central Bank, Mario Draghi, on January 25 pointed out the erratic movement of exchange rates and their adverse effect on financial and economic stability.
Developing economies tend to benefit more from a weak than a strong dollar. The Asian financial crisis, for example, occurred during a sharp rise in the dollar in the late 1990s.
Many countries formally or informally tie their currencies to the "American"; if the dollar grows, they have to tighten their monetary policy in order to maintain pegging.
A weaker dollar gives countries the opportunity to lower interest rates, which stimulates the national economy.
Of course, all these trends can go in the opposite direction. If large cash flows pour into emerging markets, their economies may overheat, and revalued currencies can make exporters uncompetitive, leading to an imminent crisis.
If treasury yields rise too high, then this will force capital to return to the dollar.
In addition, a sharp increase in bond yields will slow down the economy. Investors do not object to a slight weakening of the dollar and clearly do not want its excessive depreciation.
How long will it last?
The weak dynamics of the dollar could persist for some time, since the incentives for the main characters in the Cold Currency War have not changed.
The U.S. trade deficit widened last year, and fiscal expansion is likely to attract additional imports this year, so the Trump administration is likely to continue to be interested in weakening the dollar until it drops the bond market.
Moreover, by setting trading tariffs for the import of washing machines and solar panels on January 22, the Trump administration showed its willingness to use protectionist weapons.
Thus, one can hardly expect resistance to the "weak dollar policy" from Europe or Japan.
The collapse in global financial markets led to a reversal of major currencies. Now the dollar comes out from a position of strength.
Although ECB President Mario Draghi expressed concern about “currency volatility” and “language use” at a January 25 press conference, the ECB is unlikely to resist more aggressively.