The dollar has gained over the last three sessions despite no significant advances in reopening the US government. Meanwhile, safe-haven demand has surged, pushing the price of gold above the $4,000 mark. It seems counterintuitive that the dollar would be supported amid the ongoing political uncertainty and turmoil in Washington.
The thing is, the price of currencies is relative. We trade currencies in pairs, and the value of a currency is compared to a basket of other currencies. If the price of one goes up, it could actually mean that the price of its counterpart is going down. And that is the case here. While the dollar is weaker due to the current political situation, the major currencies it trades with are even weaker, making the greenback look stronger in comparison.
The Euro At Multi-Month Lows
56% of the dollar index basket is weighted on the Euro, so in large part, the dollar getting “stronger” or “weaker” depends on the EURUSD. The shared European currency has been declining due to the political situation in France. Prime Minister Sebastien Lecornu tendered his resignation on Monday, just hours after forming a government that the National Assembly broadly rejected.
French President Emmanuel Macron gave him 48 hours to try to form a new government that would meet the approval of the French Legislature. But the fractured parliament is also confronted with political leaders who see this as an opportunity to force an election that they might win. The market is pricing in few chances of Lecornou succeeding. Potentially triggering a political crisis in Europe if the far-right Eurosceptic Marine Le Pen were to win the election.
The Spending Problem
The main issue in France is spending, with the government running a deficit that exceeds the EU’s target by more than double. The prior Prime Minister lost his job after attempting to cut €44 billion in spending to balance the country’s budget. Long-term interest rates in France are rising as traders factor in the risk that the government may struggle to meet its debt obligations. Given the economic integration with the rest of the Eurozone, this is pushing up the long end of the yield curve for the whole of Europe and eroding the value of the Euro.
The situation in Japan is much different, but as far as the markets are concerned, it is part of the same thread: Spending. Incoming Prime Minister Sanae Takaichi is expected to increase government spending in a country that already has the highest debt in the world as a percentage of its economy. The yen accounts for 13.6% of the dollar index weighting. As Takaichi builds out her cabinet and presents the priorities of her government, the yen could continue to weaken, making the dollar look stronger in comparison.
Does the Debasement Trade Still Work?
Since the start of the year, traders have been selling dollars to buy assets in other economies that are expected to outperform the US. Others, worried about the global economy, have sought out safe havens, such as precious metals. This has been known as the “debasement trade”. As a result, the dollar short trade has become quite crowded.
A recent poll of FX strategists found that 75% believed the dollar would be weaker by the end of the year, largely due to the ongoing political turmoil in Washington. While that supports the price of gold, it depends on other currencies, such as the Euro, Pound, and Yen, to at least remain strong. However, those countries are facing their own political turmoil, which may cause their currencies to weaken more rapidly than the US dollar.
