How much longer can the US dollar remain strong?

Main Points

In the 2024 U.S. election, Trump's victory is likely to result in the Republican Party gaining control of both the House and Senate, forming a "single-party governance" structure. This structural political change will significantly enhance the new government's legislative momentum and policy execution efficiency. Historical experience shows that after Trump's first election in 2016, the market exhibited significant characteristics of a "reflation trade," with both the U.S. dollar index and U.S. Treasury yields rising, and major asset classes generally displaying a risk-on preference.

The "Trump Trade 1.0" in 2016 was primarily driven by expectations of expansionary policies. The policy mix at that time included large-scale tax cuts, support for traditional energy, manufacturing repatriation, and infrastructure investment, which influenced the market through channels such as increased fiscal spending, driving investment and employment, and pushing up commodity prices. These policy expectations led to rising economic growth and inflation expectations, steepening the U.S. Treasury yield curve and strengthening the U.S. dollar index. Historical experience indicates that the market's reaction to policy expectations is often more intense than the actual effects, reflecting the "buy the expectation, sell the fact" characteristic, a pattern that was fully confirmed in subsequent trading.

Trump 2.0 governance, with reflation expectations boosting the strength of the dollar. The Trump 2.0 policy, with domestic tax cuts, will boost economic growth from the demand side, while tariffs and immigration controls will push up prices and wage levels from the supply side. The higher policy costs compared to before will reinforce economic growth and inflation expectations. Currently, there are signs of recovery in the U.S. economy, and the Federal Reserve has also begun a rate-cutting cycle. Although the current monetary environment differs from the rate-hiking environment during Trump's first election in 2016, we believe that the rise in the interest rate center under the dominance of reflation expectations will be a key factor guiding recent market trading direction. Based on this, we judge that in the short term, the current loose monetary policy environment will not significantly restrict the continuation of the strong dollar pattern.

How much longer can the dollar index rise? The Federal Reserve may be more cautious about rate cuts in December to leave room for cuts next year. We believe that before the end of the year, U.S. Treasury yields are likely to remain upward or fluctuate at high levels. Considering the future global increase in tariffs, the economies of Europe and Japan may decline more rapidly. Therefore, a weak euro and a weak yen will support a strong dollar. Although Trump wants a weak dollar, it is unlikely in the short term. When might the dollar turn weak? It could be after Trump takes office early next year, depending on the pace and intensity of policy implementation. In the baseline scenario, the dollar may fluctuate at high levels; if economic growth falls short of expectations or even enters stagflation, then the dollar will weaken.

Main Text

With the 2024 U.S. election settled, Trump has established his victory position and is likely to achieve Republican control of the majority seats in both houses of Congress, forming a complete "single-party governance" structure. This political change will grant the new government stronger legislative momentum and policy execution efficiency, which is expected to have a significant impact on the exchange rate of the U.S. dollar This article attempts to analyze the potential trends and upward space of the US dollar from two dimensions: historical experience and policy pathways.

First, reviewing the asset performance during Trump's Trade 1.0 in 2016 has certain reference significance. From November 8, 2016, when Trump unexpectedly won the election, until the end of that year, the financial market exhibited significant characteristics of a "reflation trade." Specifically, in the interest rate market, the yield on 10-year US Treasury bonds rose rapidly by 59 basis points; in the foreign exchange market, the US dollar index increased by 4.4%; in the equity market, the S&P 500 index and the Nasdaq index rose by 4.6% and 3.7%, respectively; the commodity market showed divergence, with Brent crude oil and LME copper rising by 23.4% and 5.7%, respectively, while COMEX gold fell by 10.0% under the tightening expectations of the Federal Reserve; in emerging assets, Bitcoin rose by 33.8%.

We believe that the rise of the US dollar and US Treasury yields after Trump's election in 2016 was mainly due to the market's strong expectations for his expansionary policy mix. Trump proposed a series of landmark policy initiatives at that time, including a large-scale tax reduction plan (reducing the corporate tax rate from 35% to 21%, lowering personal income tax), supporting the development of traditional energy, promoting the return of manufacturing, and increasing infrastructure investment. These policy expectations were expected to impact the market through multiple channels: first, tax cuts and infrastructure investment would directly expand fiscal spending and boost overall demand; second, the return of manufacturing policies was expected to drive domestic investment and employment; third, the support for traditional energy policies could push up commodity prices.

At that time, the market also generally expected that this policy mix would lead to accelerated economic growth and rising inflationary pressures, thus igniting the "Trump trade" (i.e., reflation trade) frenzy. Driven by these expectations, Trump Trade 1.0 began, with the US Treasury yield curve significantly steepening, and the US dollar index strengthening as the Federal Reserve's tightening expectations heated up. It is worth noting that compared to the actual effects after the policies were implemented, the market's reaction to policy expectations is often more intense, reflecting the classic "buy the expectation, sell the fact" trading model. This was fully evidenced in the asset price trends after Trump's unexpected victory in 2016, as the upward momentum of the US dollar index and 10-year US Treasury yields weakened after Trump officially took office.

Trump 2.0 governance, with reflation expectations boosting the strength of the US dollar. We have summarized the policy proposals before Trump's current term, which can be categorized into the following five main aspects: 1) Taxation: domestic tax cuts; 2) International trade: increasing tariffs; 3) Tightening immigration policies; 4) Advocating for the development of petrochemical energy and increasing domestic oil development; and 5) Implementing diplomatic isolation and reassessing ally relationships.

The market's expectations for US inflation to rise again are deepening. First, domestic tax cuts bring positive demand enhancement, promote economic growth, and simultaneously increase upward inflationary pressures Secondly, increasing tariffs and controlling immigration are negative supply shocks that will raise the prices of imported products and wage levels, which will also lead to rising inflation. After the Federal Reserve cut interest rates, combined with existing U.S. economic indicators, the U.S. economy has gradually been on the path to recovery. Trump's proposals will strengthen expectations for growth and inflation in the U.S. macroeconomy, and due to potentially more aggressive external tariffs, but a broader scope and higher standards for domestic tax cuts, we believe the policy costs of "Trump 2.0" are higher than during his first term.

It is worth noting that, unlike in 2016 when the Federal Reserve was in a rate hike cycle, this time, although in a rate-cutting environment, we believe that the rise in the interest rate center driven by re-inflation expectations will be a key factor guiding recent market trading directions. Based on this, we judge that in the short term, the current loose monetary policy environment will not significantly constrain the continuation of the strong dollar pattern.

How much longer can the dollar index rise? This Wednesday, the dollar index rose above 105.00. Trump's ascension may bring significant changes to the Federal Reserve. Trump advocates that the U.S. president has a certain say in interest rate monetary policy, while Powell's stance is more inclined towards independent operation. Considering that Trump will officially take office as president on January 20 next year, he may urge the Federal Reserve to cut interest rates, thus the Federal Reserve may be more cautious about cutting rates before the end of the year to leave room for next year's rate cuts. This Friday morning, the Federal Reserve cut rates by 25 basis points as expected. However, the interest rate decision in December may change, and there is even a chance of pausing rate cuts.

We believe that in the short term, U.S. Treasury yields are likely to remain upward or fluctuate at high levels. Additionally, with the future strengthening of global tariffs, the economies of Europe and Japan may decline faster. Therefore, a weak euro and a weak yen will support a strong dollar. Although Trump wants a weak dollar, it is unlikely in the short term. When might the dollar turn weak? We believe that after Trump takes office in January next year, based on the rhythm and intensity of various policy implementations, under the baseline scenario, the dollar may fluctuate at high levels; if economic growth falls short of expectations or even falls into stagflation, then the dollar will weaken.

Author of this article: Zhan Chunli, source: Guotai Junan Overseas Macro Research, original title: "How much longer can the dollar strengthen?"