Investment themes – The dollar, the Fed and the recent election-induced volatility

Michalis Florentiades, XM Investment Research Desk

The revelation that the FBI was reopening a probe into Secretary Clinton’s use of a private email server on Friday, October 28, was enough it seems for the markets to reassess the likely outcome of the November 8 US elections.  This has caused some volatility across a range of assets although it must also be said that the shake-up seems to remain contained for now.

Interestingly one of the biggest victims has been the US dollar.  Dollar / yen for example has fallen from around 105.4 to 103.3 while euro / dollar climbed from the sub-1.09 level to around 1.11.  The question that everyone is asking is whether the US dollar will continue to weaken.  This in turn will probably depend on the outcome of the US election, which could turn out to be the big risk event of 2016.

The US dollar has been selling off as a potential victory by Donald Trump could usher in a period of uncertainty as many analysts claim that Trump’s policies are either controversial or could hit US economic growth.  Why is that?  The easiest explanation has to do with potential trade restrictions that Trump is advocating, which invariably lead to lower overall economic output – even though the distribution of gains from trade can make for a powerful political argument in favor of protectionism.  Curtailment of immigration could also hurt the US economy, as immigration helps improve the country’s demographic profile and long-term growth prospects.

An additional consideration related to the elections is the make-up of the House of Representatives and the Senate, as in the US constitution, the President’s powers are checked by Congress.  However, given the Yellen Fed’s predisposition towards erring on the side of dovishness and caution when it comes to raising rates, any election-induced uncertainty and potential market sell-off could mean that the December rate hike is off the table.

At this point one should be reminded that any serious market sell-off and rising economic uncertainty have the power to quickly appear in business surveys that will come out before the December meeting.  Such data points could certainly spook the Fed and force it to wait further.  Even though the Fed would like to appear independent and removed from the political process, it will need to address the uncertainty and any signs of potential economic weakness.  Such a scenario could potentially lead to more selling of the US dollar and take it even lower.  The main beneficiaries from a dollar sell-off have been gold, the Japanese yen, the Swiss franc and the euro.  The Mexican Peso on the other hand was one of the few currencies that actually lost ground against the greenback as a Trump victory could lead to US-Mexico tensions.

The main scenario of course is still that of a Clinton victory, but markets were simply too complacent about the US elections previously.  The latest moves may reflect the underlying reality and chance of an electoral surprise in the US a little better.  Secretary Clinton has a mountain to climb since she is seen as the ‘establishment candidate’ at a time when there is a lot of discontent and anger in the American electorate about being left behind from the country’s economic progress.  The US election therefore provides yet another critical test of whether the current political order, which promotes free trade and globalization at the expense of the gains accruing to the few, is coming to an end.  This could be a long-term theme which will bring significant changes in the global economy.