Investors should tread carefully as the dollar heads for a rocky ride

Dollar-negative challenges in the economic and political arenas have the bulls turning tail. The currency appears set for persistent weakness until the end of the year.

The US president Donald Trump has his hands full, struggling with the political turmoil in the US and abroad. The events in Charlottesville are adding to the pressure-cooker atmosphere in Washington. The spat and verbal threats with North Korea raised more red flags. The markets are watching uneasily.

Now, doubts arise that Mr Trump can focus his attention on the economy. From the investor’s perspective, it appears that tax and other promised reforms are being pushed to the back burner. Time – and economics – wait for no man, to paraphrase a famous saying. Any further political uncertainty could trigger more sell-offs for the dollar as we move into the last quarter.

On top of political factors, macroeconomic factors are weighing on the dollar. Possibly the heaviest weight on sentiment is the US$20 trillion in public sector debt. What the markets want and fear at the same time is an increase in the debt ceiling. It is wanted because the business of government clearly has to continue. There doesn’t appear to be a realistic alternative to increasing the limit. Any delays in raising the bar would most likely trigger volatility and another dollar sell-off.

If the debt ceiling is raised, at least stability could be assumed. On the other hand, boosting the ceiling is feared because of the risks involved in excessive sovereign debt. The 2007 sub-prime crisis proved that the phrase “too big to fail” doesn’t apply much anymore. Balancing repayments and servicing a higher level of debt would be difficult unless the economy starts booming. It is not ready to boom just yet. Grow, yes. Boom, not so much.

Most of the American economic fundamentals are on an upward trend, justifying the Federal Reserve’s hawkish stance in the first half of the year. The British pound is heading towards 2.3 per cent full-year growth, and unemployment is under 5 per cent. But June and July’s slower inflation levels clipped the hawk’s wings.

Traditionally, interest rate hikes are monetary policy’s kryptonite against inflationary pressures. But what to do about low inflation? The question has stumped monetary policymakers since the beginning of the global economic slowdown. The response to recession is not the same as the response to recovery, but it is equally important.

Normally, monetary policy tools include lowering the key interest rate. But the Fed can hardly backtrack now without seriously denting market confidence. The Fed could also lower bank reserve levels. But considering the chaos in financial markets until not so long ago, this could backfire.

Another traditional tool is to buy up Treasury securities on the open market and stimulate spending with the new cash injections. But Janet Yellen appears reluctant and undecided on this course. With so many similar assets left over from the quantitative easing days, it might not be the most attractive course of action for the Fed. The central bank has signalled that it is preparing to clear its balance sheets but has not confirmed the how and when.

So, what is left? Given the reduced strength of monetary policy tools, a holding pattern until inflation rises is a likely approach. Meaning that – barring a rise in CPI – further interest rate hikes could be put off until the first quarter of 2018. Depending on the results, the US dollar could see more sell-offs during upcoming CPI releases, so currency investors would be wise to track them carefully.

Hussein Sayed is the chief market strategist at FXTM