Bank of America-Merrill Lynch flips between bullish and bearish on US dollar appreciation depending on the outcome of the tight presidential race.
Speaking at a press conference in Hong Kong yesterday – the day American voters headed to the polls to choose the nation’s next leader –FX and rates strategist David Woo outlined the bank’s base case.
Re-election of the incumbent Democrat Barack Obama, the 44th US president, and it tips the US dollar to appreciate; victory for Republican challenger Mitt Romney and it is bearish on appreciation.
Its argument centres on the looming fiscal-cliff issue, and legislation which, if unchanged, would result in US government tax increases and spending cuts that would cut the budget deficit but drive the country into recession.
Neither political party is able to find agreement on how to reduce the deficit. This is exacerbated by the fact that the country is forecast to hit its national debt ceiling by the end of this year.
Obama has threatened to veto a fiscal-cliff bill blocking tax hikes and spending cuts unless the Republican Party agrees to raise tax rates for the wealthy.
“From that point of view, if Obama does win and we end up with the status quo, I think the gridlock that ensues will definitely carry the highest risk of a fiscal cliff,” suggests Woo.
“If the fiscal cliff were going to materialise…even [if] a faction of the fiscal cliff was to materialise, this should be very positive for the US dollar.”
Woo reasons that the realisation of the US fiscal cliff would raise the odds of a Chinese hard-landing and intensify the eurozone recession, leading the dollar to become a safer currency alternative.
“US fiscal tightening is potentially as painful for the rest of the world as it is for the United States,” noted Woo. “The fact is that 5% of the world’s GDP is exported to the US.”
This is despite the fact that exports to the US as a share of world GDP has been declining significantly from the heights of 6.5% in 2000.
The reality of this fiscal cliff would also spell disaster for export-orientated markets exposed to the US, most pointedly China, Mexico, Canada and Korea.
More than 20% of Mexico’s GDP is dependent on US exports, while Canada’s figure is over 15%. For China and Korea, the figure is about 5%, according to the bank’s research.
BoA Merrill has calculated that a -10% drop in exports to the US would alone reduce global GDP growth by 0.5 percentage points.
“We all know to what extent fiscal tightening over the past year in Europe has already got China shaking in its boots,” warned Woo “Can you imagine [what it would be like] when the US starts tightening fiscal policy as well?”
Another argument for greenback appreciation is that US fiscal tightening would likely raise investor sentiment on the ability of the US to pay back its debt, supporting the case for the dollar to remain a reserve currency.
The bank noted, for example, that every percentage-point improvement in the US structural budget balance as a share of GDP resulted in a 7% real appreciation of the US dollar against the euro since at least 2001.