FX traders should be political junkies; US election critical for dollar
The eyes of the world are trained on the Federal Reserve’s meeting in Jackson Hole, Wyoming, but FX traders might be better off following the US election to determine the longer-term direction of the USD.
An examination of the strength of the USD against CHF, the ultimate safe-haven of the modern era, over the course of several White House administrations shows that USD typically appreciates when the real Fed funds rate is above 2%, says Greg Anderson, strategist at Citi.
Those periods during which Fed funds were more than 2%, which Anderson categorizes as times of “tight money”, saw the USD appreciate against CHF most notably during Ronald Reagan’s first term in office, from 1981 to 1985, and Bill Clinton’s second term, from 1997 to 2001.
USD has appreciated more during 'tight' periods of monetary policy
Reagan’s first term and Clinton’s second term were marked by a high real Fed funds rate that made it exceptionally attractive for FX investors to hold USD deposits relative to other assets and relative to deposits in other currencies, says Anderson.
USD appreciated most under Reagan, Clinton
However, the upcoming US election in November, pitting Obama against Republican presidential nominee Mitt Romney, reminds the FX market that, while Fed monetary policy typically outweighs fiscal policy on a daily basis, “presidents often get to choose Fed chairmen”, says Anderson. Indeed, the issue of a monetary-policy legacy will likely be at the forefront of the next US president’s agenda, with Fed chairman Ben Bernanke set to step down in January 2014.
This matters because the combination of monetary and fiscal policies – Anderson defines fiscal policy as tight if the average US Federal outlay is less than 20% of GDP – has been a key driver of USD direction, as set out in the chart below.
Bill Clinton's second term saw the strongest recent USD
Romney is likely to aim to reduce spending to 20% of GDP and has gone on record stating he would probably not seek to re-appoint Bernanke as Fed chairman.
“If Romney is so lucky as to be able to nominate Bernanke’s successor, he will presumably face strong pressure from within his party to appoint an advocate of tighter policy,” says Anderson.
“I doubt a new Fed chairman would guide monetary policy in to the tight category by the end of the 2013 to 2017 presidential term, but even a 0% real base rate may qualify as easy money in a relative sense, if other major central banks retain negative real rates and/or balance-sheet expansion policies.”
That would put Romney in the lower left-hand quadrant of the diagram above, and, if the economy improved enough to get him re-elected, move to the upper left quadrant in his second term.
Of course, the presidential race is far from over.
However, FX traders should look at current Intrade election futures, showing that Romney has a 43.8% probability of winning the presidential race and a 33.6% chance of winning Republican majorities in the House and Senate.
In contrast, the Intrade market is predicting a 16.9% probability that Obama will retain the presidency and have Democratic majorities on both sides of Congress.
Given that, the question is why the dollar is not already rallying.
Anderson points out that, in a sense, the USD is rallying – with USDCHF up 2.3% year-to-date. He concedes, however, that is mostly due to the Fed’s maintenance of consistent monetary policy during the past year, rather than politics.
“I don’t expect the USD to trade around the political theme until mid-October,” says Anderson. “At that point, [the strength of the USD] may well prove to be an important factor.”
In the grand scheme of things, Bernanke’s speech in Jackson Hole might turn out to be a sideshow.