Rhythmic Reasoning_Full Report_Final_EN - Flipbook - Page 18
THE DRUMMER'S EAR | RHYTHMIC REASONING
In addition to the prospect of a significantly lower policy rate, we
expect weak fiscal policy settings to weigh on the USD outlook.
Following the passage of President Trump’s recent tax bill, work
done by our Scotia Economics colleagues suggests that the wider
U.S. fiscal deficit alone (which may reach close to 7%/GDP over the
next few years under our base case assumption) likely means a 2.6–
3.6% drop in the broad value of the USD through 2026 and more
losses in the medium term.
Fig. 2: Narrowing of U.S. yield advantage is dollar-negative
2%
105
1%
95
0%
85
2021
-1%
Index
Spread
115
2022
DXY dollar index (LHS)
2023
2024
2025
US 2y OIS spread, DXY-weighted (RHS)
Source: Bloomberg Finance LP, Scotia Wealth Management
A weak phase in the USD, driven at least in part by weak fiscal policy
would be very much in keeping with the broad, historic evolution in
the U.S. exchange rate since the 1970s. Bouts of USD strength are
typically driven by superior fundamentals and yields on U.S. assets
while bearish USD phases have typically reflected rising investor
concerns about structural negatives that have developed in the
U.S. economy, reflected by large and persistent trade and fiscal
shortfalls (as was the case in the 1980s and again in the early 2000s
when the U.S. “twin deficits” drove the USD sharply lower).
A final point to consider in the broad outlook for the USD is the
abiding impression that a weaker exchange rate may be part of the
aggressively mercantilist policy the U.S. administration is pursuing.
While the desire for a lower USD has not been explicitly stated,
U.S. officials have not protested the 11% or so decline in the USD
versus the core majors since the start of the year, suggesting the
tacit endorsement at least of its decline.
To some extent, the sharp fall in the USD this year suggests that
a lot of the negative factors around the USD are already at least
partially priced in. This may mean that the USD holds in a lower
range over the course of the next few months until markets get a
stronger sense of how much easing the Fed is likely to undertake—
and how quickly those rate cuts are likely to emerge—as well as the
extent to which tariff policy will dampen U.S. growth.
We think there are several market-driven pointers that suggest
the balance of risks remains tilted firmly towards a weaker USD
emerging in the medium to longer term. Options pricing continues
to reflect a mild premium for dollar puts over calls for 3m tenors.
Longer-term pricing reflects a greater implied probability of the
USD trading lower against the euro (EUR) into the end of this year
and next. Record gold prices are another pointer in support of the
weak dollar narrative. Finally, we note that the evolution in broader
dollar price action continues to track quite closely the pattern of
trade in the exchange rate in late 2016 and through 2017, around
the election and early stages of President Trump’s first term, in
other words. If that pattern remains any sort of guide, the USD may
steady or firm modestly in the next few months before sliding to
new cycle lows in H1 next year.
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