FX Market Calms Post-Trump Shockwave: Return to Traditional Drivers

Article Summary

• FX market volatility drops to pre-Trump election levels.
• The impact of trade tensions and protectionist policies on the dollar diminishes.
• A return to interest rate differentials between countries as a key determinant of exchange rates.
• The dollar regains its safe-haven status amid global pressures.

The foreign exchange market appears to have weathered the storm triggered by President Trump's policies earlier this year, with dollar volatility indicators falling to levels seen before the US presidential election. According to data from CME Group, expectations of dollar volatility against the euro and yen, which surged after Trump's election in November, have fallen to their lowest levels in over a year.

Meanwhile, the dollar index, which measures the dollar's value against a basket of major currencies including the pound and euro, has recovered much of the ground it lost earlier in the year and is trading near the levels from which it began its ascent before Trump's victory.

Investors and analysts say a series of tariff agreements reached with major US trading partners have helped to calm markets, and that the US economy has proven more resilient to trade shocks than many had anticipated. In addition, major central banks around the world appear to be nearing the end of their rate-cutting cycles, removing another source of market instability.

Chris Turner, head of markets research at ING, says: "The world is learning to live with Trump, and investors have learned to take headlines with a pinch of salt and not to be easily swayed."

Before the US election, markets had bet that Republican trade and tax policies would boost the world's largest economy and its currency, a trade dubbed the "Trump trade," and pushed the dollar higher. However, when Trump announced tariffs in April, this logic was turned upside down, and the foreign exchange market was hit hard, with average daily foreign exchange trading volumes reaching nearly $10 trillion.

Fears about the potential impact of trade disputes on the domestic economy, and doubts about the Federal Reserve's independence, led the dollar to its worst start to the year since the 1970s. But since the summer, the dollar has been slowly recovering, boosted by a rally in the US stock market, which briefly pushed Wall Street to record highs before the recent correction in technology stocks.

Some large fund managers believe that previous concerns about US assets were overblown. Robert Tipp, head of global bonds at PGIM, says: "Although some people are talking about the end of 'American exceptionalism', the dollar has generally been a strong currency in recent years." He sees this year's decline in the dollar as a "correction in the bull market" rather than a "beginning of the end."

In a report last week, George Saravelos of Deutsche Bank wrote that the sharp decline in volatility expectations means the market is saying that "the Trump shock is over." He pointed out that trade tensions are easing and that fiscal policy has entered "autopilot" mode. "What else can Trump do to shock the market? We ourselves find it hard to think of an answer."

Analysts say the longest government shutdown in US history, which led to a lack of macroeconomic data, also helped to calm volatility in the dollar and US Treasury market. Due to a lack of comprehensive data on inflation, the labor market, and consumer spending, investors have remained on the sidelines, avoiding building large positions.

Since the government shutdown, the ICE Move index, which measures volatility in the US Treasury market, has fallen to its lowest level in four years.

The dollar also received a boost from last month's Federal Reserve meeting. At that meeting, the Federal Reserve cut interest rates, but warned that the next cut was not a "done deal." Slowing the pace of rate cuts usually supports the domestic currency.

Investors say this suggests that the dollar is now responding again to the traditional drivers of exchange rates, primarily interest rate differentials between countries. ING's Turner says: "We have returned to more traditional FX drivers."

Other data from CME Group shows that demand for dollar call options, which bet on its rise, far outweighs demand for put options, which bet on its decline, by the largest amount since February.

Some fund managers believe that the dollar is regaining its traditional role as a "stabilizer" in investment portfolios, as it tends to rise in times of global stress. Previously, after Trump launched his first trade wars in April, the dollar fell alongside risky assets, raising questions about its nature as a safe haven.

Rushabh Amin, portfolio manager at Allspring Global Investments, believes that the situation at the beginning of the year was "more of an anomaly than a long-term trend." He says: "We believe the dollar will continue to play the role of a portfolio diversification tool in the future, especially for foreign investors."