Capital Wars (Not Trade Wars)

Why Trump 2.0 Should Quickly Jettison Fed Chair Powell

America is winning the Capital Wars. Capital is shifting and cross-border flows are surging into Trump 2.0 America, reinforcing and further propelling the already strong US dollar higher. Trump has hinted he wants a softer exchange rate. Yet, this may prove tricky and few investors seem to be thinking about the implications of a far stronger, Reagan-like, US currency.

In our view, the dollar will be further supported by Trump 2.0 policies. What’s more, these strong capital inflows also underpin US asset markets. In fact, as noted in our book Capital Wars (2020, Palgrave), they are channeled into Wall Street via a real exchange rate adjustment mechanism. Put another way, the ‘everything rally’ and the rising dollar are closely connected.

This same pattern of strong capital inflows; a strong exchange rate and strong asset markets has been seen several times before in global finance over recent decades. Spoiler alert: these booms all end badly, usually in financial crashes and recessions. Evidence, Japan 1980s; Emerging Asia 1990s; Eurozone 2000s; China 2010s, and America once before in the 1920s.

What often pulls the trigger is a spill-over of excess liquidity into real economies that fuels consumer excess and rising high street inflation. Policy makers get distracted by the party and so prove too slow to remove the punch-bowl, which means they ultimately are forced to tighten harder, later. Unsurprisingly, markets dive. The lesson for investors is to understand these bubble processes and to watch inflation metrics carefully. The lesson for the Fed and other policy makers is to be robust and not rush to cut interest rates. Rather let capital inflows drive up the dollar. But this may not be what Fed Chair Powell is thinking!

In fact, for some time global money has liked what it sees in the US dollar and, right now, it seems to like the Trump 2.0 Dollar even more. We know that international investors favor low taxes and less regulation. They lean towards pro-growth policies and they are comforted by firm and steady Central Banks with solid inflation-fighting integrity. On top of a favorable fiscal/ monetary policy mix, Trump’s pending tariff increases could dampen future US dollar recycling and, hence, by curtailing supplies, drive the US dollar still higher. The chart below reports capital inflows into US financial assets. These inflows remain strongly net positive and latest data show renewed vigor.

Our second chart takes a long-term perspective of the US currency. It shows a favoured metric, the real (inflation-adjusted) trade-weighted US dollar basket, starting from the early 1960s. The long downtrend in the real US dollar was snapped by the 2008/09 GFC. The causes of this reversal were partly America’s technological advantages; partly re-regulation following the GFC which boosted demand for US ‘safe’ assets; partly the 2010-12 Eurozone banking crisis which sullied the Euro, and partly China’s 2015-16 anti-corruption drive, which further boosted US dollar demand. The real US dollar exchange rate is currently enjoying an 2-3% annual trend appreciation that is so far unchallenged. Trump 2.0 did not cause this upwave, but his policies should add to it. In fact, it may be hard to rule out the nominal DXY basket testing a 10-15% higher index reading of close to 120. Foreigners should buy!

But there will be costs: a rising US dollar is deflationary for both Global Liquidity and World commodity prices. Each 10% rise in the DXY Index cuts our GLI (Global Liquidity Index) by 7-8 index points, or some 10-15% at current readings. This is unambiguously negative for risk assets and may translate into a 15-20% fall in World equities. However, given that the US still enjoys net capital inflows, US asset markets should enjoy continued monetary inflation, leaving other economies to bear the brunt of this monetary deflation. In short, the strong dollar will allow Wall Street to further outperform.

The more the US unit rises in value the greater the monetary deflationary impact on the Rest of the World. Unless it can be offset by monetary easing from the US Fed or from elsewhere, an ever stronger dollar and further monetary deflation could even tip the World economy into recession. Plainly, this is a key risk given the limited ability of other economies to offer support through further monetary and/ or fiscal stimulus.

But with the new Administration pending and sticky US inflation a nagging worry, the path towards further Fed easing is also far from straightforward. In a private interview a few months ago, new US Treasury Secretary Scott Bessent argued that Trump 2.0 policies would be ‘deflationary’ not ‘inflationary’. He also dismissively compared Janet Yellen’s reliance on short-term Treasury funding to an Emerging Market policy maker, and labelled Fed Chair Powell ‘unpatriotic’ for keeping US interest rates too low and so fueling inflation. All strong meat for the dollar? Bessent sounds hawkish and speaks like a ‘hard money’ man.

Could this end America’s bull market? The key risk, in our view, comes from higher inflation, rather than World recession and rising default risks from offshore dollar borrowers. Better to tackle inflation risks early in Trump’s term than to let inflation persist and worsen, thereby scuppering hopes at the Mid-term Elections in 2026. Leaving adjustment longer could force a currently dovish and reluctant Fed to more sharply tighten later.

Evidence Japan’s policy response in the late-1980s, following the similar strong inflows into the Yen. Trade competitiveness concerns made Japanese policy makers unwilling to fully revalue the Yen upwards. They made some concessions, but arguably not by enough to prevent major asset bubbles forming in the real estate and equity markets. In other words, domestic monetary conditions were kept too loose for too long.

While local analysts focused more on the stable price of rice, which dominated the CPI basket, the less monitored jump in service sector inflation in 1989 gave BoJ Governor Mieno the excuse to suddenly tighten monetary policy. His rate hike burst the equity bubble and derailed the equally fragile real estate market. Japanese policy makers then embarked on a deliberate and sustained monetary deflation that pushed the Yen ever higher and asset markets ever lower. Any hint of high street inflation was subsequently excoriated and price deflation became embedded in the Japanese consumer psyche.

Today, structural US capital inflows underpin the US dollar, much like they supported the 1980s Japanese Yen. Similarly, stubborn core inflation is the bogey that may ultimately scupper America’s bull market unless it is soon addressed. During the Reagan boom years, the markets liked the toughness of Fed Chairman Volcker. In contrast, ‘Transitory Inflation’ Chair Powell is tainted and is no inflation hawk. This risk could encourage Trump to more quickly replace him at the Fed? That would be true ‘Forward Guidance’ for investors, par excellence.